Written by Lee Stoerzinger, CFP®
When we think about investing and money management, there are certain things we have come to understand as rules of engagement. These are items like “buy low, sell high”, “don’t try to time the market”, “keep your emotions out of it”, and “follow a disciplined approach”. One thing which seems to be at the top of the list is “diversify”.There are many reasons for diversification, such as not having all your eggs in one basket, reducing risk, preserving capital, etc. In line with that is one thing which is rarely discussed, let alone understood. Where does risk come from in portfolios, and how does it affect performance?
As the investment industry has matured over the years, it has become a forgone conclusion that we need to diversify our investments. Think about the choices we have in our 401ks. They are basically a sliding scale from conservative to aggressive, and one must choose which fits best for their personal situation. If we are more risk averse, maybe we put 20% in stocks and 80% in bonds. For the risk takers, they may place much more in stocks. However, it still leaves out the most important part; how do we actually measure the risk in the choices we make?
Let’s say we have a traditional 50/50 portfolio. This means 50% is in stocks and 50% is in bonds. We may feel solid in this decision because we have enough growth opportunity and downside protection as well. However, while the stocks may only be 50% of the total, they may represent 95% of the total risk. (Read that again). It’s not just what percent is in each, but how it works together overall. So, it becomes important to not only know how the stock side is built, but what else we are using on the conservative side to mitigate on the downside. For example, think about twelve ounces of liquid, half is beer and half whiskey. Drinking the beer may be quite mild. However, drinking six ounces if whiskey may produce a different result. The ratio is the same, but it would be important to understand where the risk comes from.
One of things we offer as a firm in the advanced planning area is a deep understanding of asset allocation and how to manage risk. With the speed in which markets move and a truly global investment arena, it has become essential to understand risk on a much deeper basis than just ratios of asset classes, which is what so many firms offer today. This includes correlation analysis, using non-traditional assets, and even behavioral science to manage expectations. We understand that markets have done well in recent times and have made this analysis less obvious. Much of this becomes clear when markets move downward or sideways. This also happens to be when it matters most, and when we add the most value to our clients.