July 2011: Thoughts on Risk

Dear Clients and Friends,

I hope everyone is having an enjoyable summer!  Here in San Francisco, summer means it is cold, foggy and windy.  Fortunately, by the time you read this, Mrs. Bootstrap and I will have jetted off to sunny, hot Atlanta for a weekend of family, fun and warmth.  Before I leave, I wanted to share with you my view on a very important investing topic.

Thoughts on Investment Risk
(Or: Learning to Love the Roller Coaster)

It is an investment truism that no one thinks about risk when times are good and the market is rising, but they think about little else when the market is falling.  In fact, many professional investors really owe their success to the fact that they focus on investment risk in good markets and bad.  This focus on risk is extremely difficult to maintain, as we will discuss, because in many cases it can come at the expense of bull market returns (these are markets where prices rise over time).  In finance theory, risk takes many forms: investment volatility, interest rates, exchange rate risk on your non-US investments, the list goes on and on.  In my opinion, for the individual investor, risk represents permanent loss of capital.  That is when you suffer a loss on your investment and you sell out - often in the process abandoning your investment strategy altogether.  Given this definition, the biggest obstacle to successful investing is most likely to be ourselves.

So now you know what I mean by risk.  If you are like many investors you may have taken an on-line survey that said you had a high or medium risk tolerance and as a result you were highly invested in equities.  Then after you have seen the value of your portfolio plummet, you are not quite so sure that you have the risk tolerance you thought you did – it reminds me of a song, (The Scientist by Coldplay), “Nobody said it was easy... No one ever said it would be so hard” (emphasis mine).  Suddenly, you decide that you shouldn't be nearly as heavily invested in equities and you sell your investments or change your strategy.  Of course then you miss the beginning of the next big rally.  It is enough to drive a person mad... or at least out of investing.  First of all, don’t beat yourself up.  Advisors and pundits tend to treat the whole risk thing as if it were an easily quantifiable variable.  But what seems riskless on a sunny day in April 2007, can seem much more risky in November of 2008 when your company is downsizing, and the equity in your home has been decimated.  I think one good thing that has come out of the market turmoil of the last few years is that people really have some experience with how they may handle a large loss on their portfolio.

For those of you who have worked with me for a while, you know I am somewhat obsessed with talking about risk and walking through these types of bear market simulations (bear markets are characterized by steep declines in prices).  I believe this is a very important aspect to investment strategy and I want clients to be mentally prepared for the next bear market so that they can stick to their investment strategy and take advantage of the opportunity rather than abandoning the market.  The reason is that bull market returns have a tendency to be long and drawn out.  During a bull market, returns can deliver single digit and double digit returns for several years.  Bear markets, however, have a tendency to be relatively shorter and of greater magnitude – 20%, 30% or even 50% decline in a single year.  If you look at long term graph of the market (go ahead, I’ll wait…) you can see an overall uptrend with intermittent abrupt drops.  A friend of mine reminded me of an investing saying, "A bull goes up the steps... A bear goes out the window."  These abrupt drops are what challenge the fortitude of many investors; but I believe how you react to bear markets will have a far greater affect on your investment program than what you do in bull markets.

Here's why: this bull-bear pattern of returns can lead to investor complacency or what I call "allocation drift".  This is where an investor lets the stock portion of their portfolio rise far beyond their initial plan due to the out performance vs. bonds. Then they are surprised when their portfolio drops significantly during a bear market and they risk abandoning their investment discipline at exactly the wrong moment.  Whether aggressive or conservative, the key to having a successful strategy is maintaining the discipline required to re-balance your portfolio despite whatever the markets throw at you.  And keep in mind, a conservative portfolio is not synonymous with easy.  It can be very hard to sell your winning equities in 4 years out of 5 to add to your slower growth bonds in order to protect your portfolio in the event of a decline.

I think it is hugely valuable to play investing “what-if” games.  Thinking through the implications of a large decline to your portfolio and modeling the real world impact can really help you understand your appetite for risk.  If you decide you need to dial back your risk level, that is OK.  Just make sure you have the discipline to see your strategy through.

If your friends and family have questions about investment risk or any other financial issue, please don't hesitate to make an introduction or forward this letter.  We provide Financial Planning and Investment Management services and would be happy to talk with your acquaintances.  We will treat your friends and family with the same care and diligence that we treat you.

 
Thanks,

Brian McCann