Transcription
Paul Winkler: Hey, this is Paul Winkler. You’re listening to the Investor Coaching Show. Okay. So what I’d like to talk about today, and I’ll start off with is talking about the risk of investment portfolios. How do we, how do we figure out what risk we ought to be taking in the investment process? And I can’t go through everything cause it’s a pretty detailed process, but I want to pick on an industry practice and talk about why the industry practice in my humble opinion is problematic. And many of you have probably gone through this process before with investing and investment advisors or investment firms, and you have to answer a questionnaire, our risk tolerance questionnaire.
Risk is a balancing act
Now the idea behind risk is this: risk is a balancing act. You know, if we take too much market risk, we can have lots of volatility and it can be hard to sleep when you’ve got a portfolio that’s fluctuating awhile. And, and you know, the reality of it is a lot of times investors take risks that they’re not getting paid to take. That’s a really important concept to get. What investors will do is they’ll invest in like individual stocks or maybe portfolios that aren’t as well diversified as they should be.
You’ve heard me talk about target date funds all the time here are pre allocated portfolios, investment firms, how they put together portfolios that are overly concentrated in big US companies. And you can have periods of time, like, you know, recent years then. Okay. Not a big problem. Big US companies have actually done really well under Trump and have done well in general because of some of the policies that he’s instituted and some of the things going on and how he’s been treating other countries around the world and China and so on, so forth, but in many areas in history and you know, that same thing happened in Reagan’s first term.
You know, things really, really went well for big US companies, second term, not nearly as much, you know, other countries around the world, way, way, way better returns. Whether, whether I’ll repeat it or not, who knows. But the point is that under Trump’s policies, that area of the market has done well. And it’s given people a feeling of being a little bit bulletproof. Now the same thing happened in the late nineties. People felt a bit bulletproof that you know, that there was safety that they really didn’t have.
They didn’t realize they were taking the risk because these companies are big, they’re the best known companies out there and see they had the best returns recently. So people felt really, really okay about themselves until the bottom fell out. Then all of a sudden they didn’t feel so. Okay. So when we’re talking about taking risks that you’re not paid to take, that’s a really bad move, but in general markets have risk, even if you’re properly diversified. Even if you spread out amongst large and small and value and growth and international and US and all these different areas of the market, people didn’t jump into commodities and I would just go, nah, that’s real estate.
Inflation risk
That is not something I would include in an investment portfolio, but you see that kind of stuff. And I would look at that as going, gee, here we go. We’re going to take risks that we’re not getting paid to take again by doing that, but that’s a different show. So what happens with the investment portfolio is you have to look at, well, what’s the person’s age. You know, you’re, you’re looking at how old they are, how many years before they’re going to retire, what their income is going to be from other sources. You know, those are all types of things that we look at and more about that in a second.
But you know, there are things that we have to think about regarding risk, because if we just look at market risk, we’ve got a problem on our hands because there’s inflation risk. If I put all my money in fixed investments or in like treasury bills or CDs or things like that, you know, like the rate of return on CDs, like, you know, 1% inflation rate is like two. So I’m losing one and it’s even, but it was even higher last year, a one, one and a half percent I’m losing right off the bat. And if I’m trying to take an investment portfolio where I’m drawing income down and I’m losing to inflation, I have a problem in my hands.
I can’t possibly do that. It’s just unattainable. It’s not going to work. So I’ve got to actually balance the risks and make sure that I’m not taking risks, that you know, that I’m not from an inflation standpoint, I’m not putting myself at risk there. I’ve got to make sure that I’m dealing with not only that, but also liquidity risk. You know, what’s the risk that I, you know, like the real estate that I just mentioned a second ago, a lot of these real estate trusts and things like that, investments are illiquid. It’s a different type of risk and risk tolerance.
Market risk
Questionnaires don’t really deal with that. They’re dealing with the market risk. Now, if I have too much in equities, too much in stocks, I’m dealing with something called sequence of returns risk, and that can be problematic as well. So it’s a balancing act, as I said. And what that is in English is that when markets go up and I’m taking an income, I’m cool. Let’s say if you know, my portfolio goes up 20% and I’m taking a 4% draw from my investment portfolio, it goes up %20.
I’m good. Cause I’m 16% the better after even after I’ve taken my money out of the account. Right? And it goes up 10%, I’ve taken 4% out. I’m 6% of the better. I’m always okay. When the market is going up, in those scenarios. And that is a sequence, which is when the market went up, that’s the sequence. You know, it, it did. Okay. Now, if the market happens to go down, I have to sell more securities to get the income.
So there I’m running into a problem. I’m running into a problem that if my portfolio went down 5% and I had to pull a 4% distribution out, I just went down nine. Right? So I actually had to sell stuff low, which is the opposite of what you want to do as an investor. You know, you want to buy: buy low, sell high. There, you’re having to sell low. So you have to watch how much volatility is in the investment portfolio. And it’s fairly complex when you look at it that way and you try to balance it as to, well, how much of that?
So how do you do that? Well, looking at somebody’s risk tolerance and judging it that way is not terribly helpful. And there’s academic research to back this up. And you know me, I’m always focusing on academic research because you know, if I’m going to make a decision that is going to affect my clients, it’s not going to be based on feelings. It’s not going to be based on, you know, anything that is, that can change from day to day. But you know, I’ve always been real sensitive.
These are some of the things I’m always thinking about: matching market risks, taken by a client, or an investor based on their risk profile as best you can determine it. But there are a lot of things that go beyond risk tolerance that determined that. And I’ll talk about them because I think it’s incredibly important that you understand this stuff. Now there was a study.
Risk tolerance projection
It was called risk tolerance projection. Yes. Vividness. And this, the study was fascinating because what it said in that was this, it said that risk tolerance fluctuates in part due to changes in investment markets. Okay. So what do we have right away? What do markets do every single day? They change. Yes. They go up, they go down. So if I am doing a risk tolerance questionnaire and the market changes, then what has changed as well, the risk tolerance.
So what does that tell me? I’ve got to make a change in the investment portfolio based on what, what the market did every single day, it’s going to be something different. Right? And what happens is they use these things called regression tests and they conduct these things to determine the role of projection bias and projection bias. In English, investors try to project what the market’s going to do. What do they do when they’re projecting? They typically continue whatever the pattern was that they just saw.
So if markets are going up, they are projected in the future. More of what up, if the market just went down, what are they doing? They’re projecting more down because they’re hearing in the media, why the market went down and they’re just figuring it’s going to just continue. That’s what’s going to happen. So this projection bias, they actually studied this in particular study and in this research. And what they found was that individuals who own stocks tend to use recent and vivid market data when establishing risk attitudes in English.
We remember that, which we just went through and that is what’s called Cincy bias is what it’s called in academics. So yeah, I just remember stuff that just happened. Cause it just happened. It’s just easier to remember. And it’s more vivid in my mind. And what happens is these risk attitudes change on average in the aggregate. And they’re fluctuating with the closing stock prices of the previous week. So you can see how ridiculous it is to use a risk tolerance questionnaire when constantly risk tolerance is changing.
Remember the golden rule of investing
And what happens is investors tend to vacillate in their opinion, on the stock market. Some days they think it’s great, something, they think it’s going to go higher and sometimes they think it’s going to go down. And the problem here is that we would be driven to change asset mixes at the worst possible time. So if you’re sitting there in a 401(k) meeting, let me just bring this down to real. You’re sitting in a 401(k) meeting and then an advisor says, “fill out this risk tolerance questionnaire.” How would you respond? If the market went up 15%, I would buy more.
I would start, I would just leave my money the way it is. I would buy less. You know, if the market drops 15%, what would you do? I would sell, I would buy more. I would just sit tight. You know, they’re going through and their people are answering this stuff, but it’s based on what, when they’re answering is probably based on what they’ve just seen in the stock market. They just heard the market crash 20%, you know, in the past month or something like that. And they get a questionnaire like this, what would you do if the market went down $50, I’d sell, you know, cause it’s gonna go down.
It’s got another 5% to go or whatever. So that’s what they’re finding is that people’s attitude toward risk. So people are less risk tolerant. They don’t like risk as much when the market has just gone down. So what would that cause you to not want to buy? You want less stocks after the market has gone down? Well, what do we know about the golden rule of investing: buy when prices are…? Yes. Low! Sell when they’re high. So if the market’s just gone down, it’s what? Higher or lower? Lower than what it was. What should we be doing? We should be thinking about, I’m not talking about market timing here. That’s a whole different, that’s a whole different, bad thing to do. Yeah. But I shouldn’t be going, “Hey man, I want less stocks than I did before.” That would be the wrong type of response as well. Then, you know, the market goes up. I’m like, “yeah, man, I’m bulletproof.”
The market’s gonna go up forever. You know, I’ve heard that the economy, I just heard, I heard people on a major news channel yesterday, literally talking about the things going on, the Fed, as you know, it’s just not being reflected in stock prices. All the stock being market, being up, isn’t being reflected in the economy and I’m having a yell at the TV. Do you guys not know? You know, how long have you done this for a living? And you don’t realize that the stock market is a forward-looking indicator. The market is going on based on what it anticipates to be better conditions.
Not right now. It’s not the way it works. It’s looking in the future and you can, and you know, so how long do you do this without, you know, it’s like the person that has 38 years of experience. And I look at it and go, no, they got one year of experience, thirty-eight times. You’re getting too worked up. I know, I know I do. So anyway, now you’re so, so the issue here is that we’d be driven to make changes at the worst possible times, right?
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Tactical asset allocation
And if the market goes up, I want to buy when the market goes down. I want to sell. And, and this behavior is what’s called tactical asset allocation and tactical asset allocation is a form of market timing. Now, tactical, it’s sold as tactical asset allocation because it sounds much better market timing doesn’t sound good. Does it? You know, I’ve always heard that market timing is a bad idea and you know, it is, but you know, when you call it something different, it doesn’t sound so bad, but basically it’s changing your mix based on a prediction or forecast about the future market.
Timing and tactical asset allocation is a form of that. Now, what should we be looking at? Well, there are a lot of things that we ought to be looking at. We have to understand how to measure risk. How do we measure how much a portfolio could go up and down from what the expected return is? So if I’ve got, let’s say my CDs and they pay 1%, how much can the return fluctuate from that? And not a heck of a lot. I mean, you know, it can’t go down much further. It could go up, but it takes all a long time.
If you look at interest rate changes historically, they don’t happen overnight. It takes me, it took many years for the interest rates to drop from. You know, remember when they were over 10% in the 1980s, early 1980s, it took all the way til now to get them down to where they are. And, you know, back from the 1950s when they were down about what they were right now and getting them up to where they were in the 1980s, I mean, it was a long time. So it’s not as, it’s not an overnight process. So the standard deviation or the level of risk or level of change in the portfolio value is extremely slow with fixed income investments.
Now with stocks, it can be really, really quick. I mean, shoot, you have 96% of market returns occurring in 0.9% of trading days. Historically, I’m gonna just give you an idea that it’s fairly, fairly quick when markets fluctuate. Now, what happens is, if we look at history, we can determine how much a portfolio based on how it’s put together could go up or down in a given year using history, going back to the 1920. So that’s one thing that we like to do. If we want to include international stocks, we go to the 1970s, you know, 1970 to be exact.
And the reason being is that’s where the best data is. And the most comprehensive data on international markets exist in that particular area. You know? So that’s one of the things we look at is how much it can go up or go down. And what I’m gonna do is I’m gonna talk about a couple other things that I look at and give you an idea of what it is that I’m looking at when coming up with somebody’s risk measure, what they, what they should be holding in an investment portfolio. Cause I think there are a lot of things that you ought to be looking at. And I think it’s really important because I mean, shoot, you’re going to be taking an income from this investment portfolio and it might have to last you 30 years, you better get the risk and return balance, right?
I mean, it could be the difference between you making it and not making it. If you don’t take any risk, then you’ve got a huge inflation risk. You guys, literally, as I said earlier, I’ve got a 1% return on your CDs and you’ve got an inflation rate of 2%. You’re losing 1% per year. I mean, it’s just a matter of time before you run out of money. It’s a guaranteed loss. Now that means that you got to look at it. If you take too much stock risk, now you got that sequence of return risk issue that I was talking about. When markets go down, you have to sell more stock. So you have to balance those things out.
So I’ll talk more about that right after this, you’re listening to the Investor Coaching Show and I’m your host, Paul Winkler.
Risk is unavoidable
Risk is a part of the deal. You can’t avoid risk in the investing process, but you can be sure. Just be a little bit more intelligent when you’re dealing with risk and how to come up with a proper mix for a portfolio that just matches what risk that you ought to be taking or would be prudent be taking based on your financial situation. So, you know, risk tolerance, questionnaires, then I’ve talked about risk tolerance questionnaires before. And on many occasions, I actually had one of the professors from an American college on the show.
That’s where most of the training is done for certified financial planners and chartered financial consultants. And he basically flat out said, “yeah, we found that this stuff is problematic. It doesn’t work that well.” And I said, “yeah, I have been suspecting this for years.” And the reality of it is, is I find that it really hurts investors quite frankly, in many ways. And I’ll talk about that more in just a second, but what happens with risk tolerance is that it ignores it.
It really ignores a fundamental thing about people. Our desire to take risk goes way the heck down after we’ve just been through anything traumatic. I mean, think about it. If you have ever been through an auto accident, you know, have you ever gone through an auto accident or just seen one and all of a sudden you’re driving more carefully now you’re just got both hands on the wheel. You’re letting yourself be vigilant in every way. Well, that’s the same thing with investors. If you’ve just seen an auto accident in the stock markets, you’re pretty doggone vigilant when it comes to, you know, making any kind of changes in the investment portfolio and taking on any equity risk.
Cause you’re worried that, you know, if it’s just gone down and it’s just going to keep going down, well, one of the things we look at is the range of a portfolio, how much it could go up or go down and you know, that is measured by standard deviation. So in essence, I can know this, this is important that you know, that this can be known. And what it does is it says this. If I’ve got an investment portfolio with an expected return, let’s say that the expected return is 10% just to use nice, easy math. And I know that the standard deviation is 15% on the portfolio.
An example
I know that if I add 15% or I subtract 15% from that number that gives me what the range of returns would have been about 68% of the time. Historically now the standard deviation could change based on what period of time you’re looking at it. There can be some changes if I’m the longer, the better, the more data the better is, is really when I’m looking at is when I do standard deviation calculations on a portfolio, I’m going back, you know, 50 years is typically what I’m shooting for.
I’m shooting for where all the way back to 1970, because of the fact that I want as much data as I can possibly get. And I want all markets. And sometimes I even go back further than that. Just looking back when I’m just dealing with the US markets going back to the 1920s, but that’s the more data the better and what it does. It says if I got an expected return of 10%, I can say, well, 68% of the time, two thirds of a year. If I, you know, if I look at any given year in history, two out of three of them, the return was somewhere between 10% plus 15%, it’s 25%. Or 10% minus 15%, it’s -5%.
Then if I look at us like, okay, well now that’s 32% of the returns that are falling outside of that. Paul that’s a lot. Yeah. So what we do is we, if we want it to be 95% confidence level, we take another 15% on top of that. So it’s 10% plus 30%, which is 40%, right.
And 10% minus 30% would be negative 20%. I would know that 95% of my returns would fall between those two numbers, 40% or negative 20%. I could have a risk of a 40% return. Is that the way I like to put it to be because that’s Whoa, that’s just, that’s not what I think of reserve risk that I could have a really high return. I think of what’s my risk of losing 20%. So that’s the way academics view risk. So this is what you do say, okay, well, I can’t handle that much of a range because I’m going to be taking income and the sequence of returns risk that you talked about, you know, that I talked about earlier, that could cause a problem.
If I have that much of a downside, let’s say for this particular client, based on the amount of income they’re taking now, the less income you’re taking from an investment portfolio. If you’re only taking a 2% distribution per year or a 3% distribution, then that may be fine. But for a person taking a higher distribution rate that may not work out as well. So you’ve got to balance this stuff. You see, it can be fairly complex. Now what happens is that we look at that and now we can say, okay, so now if I know the one year risk range, I can do a multi-year as well.
So what if my time horizon is 10 years or 9 years. Now, what I can do is 9 years. I’m using that because I divide by the square root of the number of years. And I got a new standard deviation number. And you, I can figure out what the range would be, what my likely returns would be over a longer period of time. And that is it’s handy to know this stuff. And most people don’t even know that it can be known, so what happens? This is, these are the types of things that I think we ought to be looking at as an investment industry.
This is the stuff that actually should be fine focused on rather than, Hey, what would you do after the market went down, you know, 10% or something like that? Well, the reality of it is that as an investor there, what they’re going to do depends a whole heck of a lot on what their education has been and what the advisor has taught them and how much they understand about markets. And that’s, what’s not happening in the investment industry. Most people don’t, they don’t get what they’ve got.
Don’t blindly trust
They’ve just delegated. And they’re blindly trusting the investment advisor and the investment. We look at it and go, no, you’re going to understand that you don’t have to know everything we know, but you’ve got to know these really important things about how much risk and help markets work. If they go down, what makes them come back? And if you’ve been listening to this show for a long time, you’ve heard me talk about why markets always bounce back when they go down. Why do they always come back? You know, and I talk about that kind of thing. And I teach in great detail because I’ve got to get you to the point where you get it well enough that you’re not afraid of it really super, super important.
You’re listening to the Investor Coaching Show. And I’m your host, Paul Winkler. We’ll see you next time.
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