Commentary
Managing Investment Risks
Everyone would agree that it is impossible to predict future stock market returns. Investment models can produce hypothetical returns but they clearly can’t account for future events. So, investors who manage their investments based on market performance or what they perceive as opportunities for better returns have very little control over the outcome.
On the other hand, risk is a certainty. There will always be market risk, interest rate risk, inflation risk and taxation risk. If your investment portfolio is not vulnerable to market risk it is most likely vulnerable to interest rate or inflation risk. We also know that, over the long term, taxes can impede returns and portfolio performance. If it were possible to control the risks to your portfolio, then you could improve the long term performance of your investments.
Understanding Risk
Most investors understand the concept of risk and reward – that, in order to achieve higher returns, you have to be able and willing to assume a commensurate amount of risk. So, investors who seek an annual return of 12% on their investments should be able to tolerate a higher amount of risk than the investor who is satisfied with a 3% annual return. The risk of loss associated with the stock market is called “market risk”.
Many investors who were rattled from the steep declines in the market during the 2008 crash, and more recently in the August 2011 plunge, have decided they have little tolerance left for market risk, and many of them have moved their money to “less risky” investments, such as Treasury securities or low yielding cash vehicles. The problem for these investors is they have now left their portfolio vulnerable to other adverse risks. Effectively managing all of your risks entails allocating your investments along a mix of assets that can act as counter-weights to the various types of risk. A Balanced investment objective can serve this purpose as it is designed to combine the capital appreciation and growth potential of an equity portfolio with the predictable, income-producing characteristics associated with a portfolio of fixed income instruments and the stability of a cash reserve.
Inflation Risk
There is always going to be inflation. In recent years, inflation has been very low, but there have been bouts of extremely high inflation - well into double digits- in the past. When there hasn’t been inflation, there has been deflation or stagflation, which some would consider to more dangerous conditions for investments. When investors shift their assets to low yielding or fixed yield investments to avoid market risk, they are exposing them to inflation risk.
It might seem like the prudent thing to do to move your money into a CD earning 2% with absolutely no market risk. But, if inflation were to average 4%, your assets would lose 2% of their value. Lower yielding savings or investment vehicles can’t keep pace with inflation over the long term, and the steady erosion of purchasing power is no different than suffering a loss in the stock market. It is vital to always have a portion of your assets diversified among inflation risk investments.
Inflation risk investments: Large, blue chip stocks of multi-national companies; TIPS (Treasury Inflation Protected Securities); real estate, gold or silver
Interest Rate Risk
We also know that interest rates will rise; and they will fall. Unlike changes in the direction of the stock market, changes in interest rates do come with some forewarning. For instance, when the economy slows down as it has since 2008, the Federal Reserve will lower interest rates to try to stimulate economic activity. Conversely, when the economy begins to overheat, the Feds will increase rates to try to contain inflation. Generally, when interest rates rise, the prices of debt securities decrease, and in a declining interest rate environment their prices will increase.
People who stash their money in fixed yield vehicles are also vulnerable to interest rate changes. If you lock your money into a five-year CD at a rate of 2%, and interest rates rise over that period, you have lost the opportunity to earn a higher return. Similarly, if interest rates decline over that period, you will likely have to roll your money into a lower yielding CD.
Interest rate risk investments: Dividend-paying stocks, market adjusted CDs,
Taxation Risk
Nothing except death is more certain than taxes. At one time or another, the IRS will collect its share of your investment earnings. But, as imposing as the tax code is, it does allow investors to use all legitimate means to minimize and even avoid taxes. Deferring taxes, which can be done using qualified retirement plans like IRAs, 401Ks and the like, enables your earnings to compound unimpeded by taxes so they can accumulate more quickly. However, there is usually a tax consequence when you eventually access those funds. Understanding investment taxation, such as capital gains, loss carry forward, investment income, etc., is critical to maximizing the long term growth of your assets.
Taxation risk investments: Tax exempt bonds, annuities, qualified retirement plans, college 529 savings plans, tax-efficient mutual funds, index funds, ETFs, REITs.
The most effective way to manage and minimize all investment risk is through the broad diversification of assets under a long-term investment strategy. Investors should always consider their long-term objectives and overall tolerance for risk when selecting investments.
What are your Portfolio Performance Expectations?
In the story of Alice in Wonderland, Alice arrives at a fork in the road and wonders aloud which road to take. A smiling Cheshire Cat appears and asks her what her destination is, to which she replies, “I don’t know.” The toothy cat then proffers the only possible response, “Well, then it doesn’t matter.”
While it’s not the type of exchange that might actually occur in our lives, it should, especially as we consider our financial future. For many people, who have yet to clearly define their financial destination, it probably doesn’t matter to them which path they choose, if they choose a path at all. That may be one way to explain why many Americans are not on track to meeting their retirement goals, or worse, why most couldn’t tell you where they stand today in relation to their goals.
When You Don’t Know Where You’re Headed…
It would also explain why many investors focus on the latest mutual fund returns, or finding the next hot fund instead of their financial goals. It might also be the reason why investors follow the herd and flee the market after it crashes or buy into it only after it has peaked – investment traps too many investors fall into, even though it has been academically verified that such behavior invariably leads to losses or poor portfolio performance. They have no destination, so any path will get them there.
If your investment expectations reside in the current performance of the markets, it probably means you have yet to clearly define your long-term financial objectives, because, what happens today, tomorrow or next year in the markets will have little if any bearing on your long-term objectives.
The Only Performance Measurement that Matters
If, however, your investment or portfolio expectations are based purely on its ability to get you to your specific destination, it means you either have or are ready for a solid investment strategy. The only way to measure the outcomes of your investment decisions is to compare them to your specific objectives, not by comparing them to market indices. And, only through a deliberate planning process will you be able to choose the path that will get you to your destination on time. So, as a matter of course, we take our clients through a comprehensive process that includes:
- Thoroughly assessing your financial situation and goals
- Clearly define long-term investment objectives
- Develop an Asset Allocation Plan customized to your investment profile
- Fully implement your selected investment strategy
- Monitor and Rebalance Your Portfolio
From there, our clients expect their portfolio performance to keep them on the path to their desired destination without assuming any more risk than is necessary and with minimal costs. And, with the right kind of investment coaching, they will choose patience and discipline over hot stock tips and the top mutual fund de jour because they know what actually leads to long-term investment success.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.
