I was listening to the classic What Is Love? by Haddaway the other day, and it got me thinking about the basis of the song: risk. When you open your heart to another, you expose yourself to the potential of having your heart broken.
That is the risk of loving others. But risk can hurt people far outside the realm of love, and one of the most pertinent I can think of during our current economic environment is investing above your risk tolerance.
(Don’t be surprised that my mind jumped straight to finance; I am a financial advisor and personal finance blogger, after all.)
In the song above, one can replace the word love with risk, and the meaning would remain the same:
After all, pain and hurt from a broken heart stem from the loss of something cherished. When investing above one’s risk tolerance, the same will come.
Risk and reward are married
Risk and reward are integral to one another and are married like the yin and yang. Without risk, one cannot gain. And as the desire for gains increases, one must amplify their risk-taking behaviors.
Therefore, investors must be ever cognizant that things will go haywire when creating an investment plan. Maybe not today, nor tomorrow. But someday, a recession or crash will arise, causing pain reverberating across the markets.
Remember: what giveth can taketh, so be prepared.
Applying risk to investing
When you love someone, you become blinded by the fact that things can fall apart; dopamine is a powerful drug.
When investing, everyone is ecstatic about gains. But as a diligent investor, you must not invest according to the potential upside you desire unless you can handle the risks of such behavior.
For example, look at the average annualized return of a diversified stock portfolio invested entirely in 70% domestic and 30% foreign equities. Since 1927, such a portfolio has returned 10.13% annually, which is commendable and similar to the 10.49% return of the prototypical benchmark S&P 500
Many in the personal finance community use historical index returns as evidence and preach to buy the index and forget. But doing so ignores the underlying reality: humans are emotional, not rational beings.
Most would gladly accept a 10% return when the going is good. Yet, a diversified portfolio using the 70/30 model above has experienced a return swing between -67.56% to +162.89% during any given year.
Talk about pain and exuberance!
Therefore, expecting new investors, those nearer to retirement, or those naturally more conservative to swallow the pain of a ~68% loss is ignorant at best.
Therefore, when someone is constructing their portfolio, they must be wholly aware of the benefits and drawbacks posed. A great way to ensure this is to ask others if they agree with your behavior assumptions.
What does risk mean, though?
Understanding why investment risk and reward are intertwined requires further explanation. Let’s briefly dive into this subject.
Low risk securtities
When holding cash, you know its value and can readily spend it. Additionally, a dollar is worth the same amount today as it will be tomorrow, minus inflation. So, holding physical currency provides safety and portability but no monetary gain.
Banks readily accept cash when you visit them to make a deposit. However, since everyone can and does this same activity, the bank doesn’t have to offer much of an interest rate to compete for your money. Instead, physical banks differentiate themselves via the service they provide. Some online banks have taken a different approach and now compete on interest yields with their savings accounts. Still, they remain relatively low since you are essentially guaranteed withdrawals at any time.
Next, there are cash equivalents. These investments include certificates of deposit and money markets. Certificates of deposit guarantee withdrawals for depositors but have time restrictions on how soon money is available. After all, the bank wants to loan out funds to make money.
With money markets, banks or brokerage firms invest your money in short-term debts converting to cash soon, paying a yield first. While you can technically lose money investing in a money market, it remains improbable and has only happened during the Great Recession. During this time, firms like Fidelity stepped in and propped up their money market funds to prevent them from losing value.
Jumping to the next level of risk, we have US government bonds. When purchasing these investments, you are (almost) guaranteed to receive your money back, plus interest (which is sometimes minimal). I say almost in the prior sentence because the US government has never defaulted on its debt. Other countries buy US debt for its security, as do pension funds. While a default remains possible, it is likely far-fetched.
Following US government bonds, we will skip to corporate bonds. These are debts issued by companies so that they can finance expansions or other activities.
Corporate debt can be either investment grade or junk. Investment grade corporate bonds pay higher yields than US government bonds since a company defaulting is more likely. Nevertheless, investment-grade bonds do not produce the highest interest payments since they tend to be relatively safe.
Medium risk securities
Next up, we will pivot into equities from fixed income instruments. The first instrument when discussing equities is large-cap stocks. These companies are well established and are (generally) profitable. They include giants like Microsoft and Johnson & Johnson, and companies in this category provide investors with yield through dividends (profit sharing) and share price appreciation.
Large-cap companies, also known as blue-chips, are a safer bet than smaller companies since they are entrenched in the economy and have large consumer bases. Nonetheless, they risk running amok or having an adverse event (such as an unexpected CEO death), which can cause investors to lose substantial money.
High risk securities
Small and Mid-cap stocks, such as Big 5 Sporting Goods, are much smaller than their larger-sized brethren. Resultantly, many are newcomers or serve smaller swaths of consumers, which means the risk of failure is higher. Traditionally, small and mid-cap companies have provided greater returns for investors since they can grow faster (doubling a million is more manageable than doubling a billion in business).
Ultra-high risk securities
Lastly, investors will find startups and junk bonds on the risk scale. These securities have the risk of going to zero/defaulting.
Startups are notoriously cash-heavy businesses that usually fail. Still, investing in one that is successful is wildly profitable.
Junk bonds are from corporate issuers with a low credit rating, posing a risk of default to lenders. Because of their low credit rating, borrowers must pay more to secure financing. Still, investors can never be confident they will see their funds again.
The case for indexed securities
Along the risk scale outlined above, investors can trade risk for returns and vice versa. Still, investing in individual stocks and bonds is less than ideal since beating the market is improbable and carries non-systemic risk.
For those new to the term, non-systemic risk means danger stems from a particular source. In our cases, this is the individual issuer. Investors can diversify their holdings to eliminate non-systemic risk through holding various securities or index funds.
When investing in broad-based index funds, you save yourself time and only face systemic risk, which is the chance of the entire economy collapsing. Therefore, wasting one’s time on holding various securities seems trivial.
How to invest according to your risk tolerance
In my article, You’re Investing Wrong: How To Use Portfolio Construction, I discussed many similar points on investing according to risk tolerance. Regardless, I felt today’s post warranted a separate article.
Many investors preach the benefits of solely investing in a Total US Stock Market Index Fund. But I demur and say such allocations are unwise. If you believe indexing is the key to success, which you should, excluding the remainder of the global economy is incongruent with logic.
Vanguard research says that 20-78%* of your total equity exposure should come from international holdings. Why? Because doing so lowers assumed risk through diversification across the globe.
I hold 20% of my total equity exposure in international stocks and believe 20-30% is ideal. Many target date funds place 40-50% of their equity holdings in global stocks.
Choose whatever level of international equities in your portfolio you feel comfortable holding. If you remain unsure, consider copying or relying on an indexed target date fund that approximates your retirement year.
Once you settle on what portion of your equity holdings will be domestic compared to international, you are ready to determine the most appropriate percentage of stocks, bonds, and cash equivalents.
The tricky part of determining your overall allocation to stocks, bonds, and cash equivalents is that you are assuming how you will react to future events. (Doing so may be entirely conceptual for those who have yet to experience a global economic meltdown.) Despite this limitation, please be honest with yourself since it is your heart that an undue risk will break.
Above, you will find a chart showing returns since 1927 for various portfolio allocations through 2019. I suggest choosing one with the upside and downside potential you can tolerate for the next five years. Then, reevaluate when that time has passed.
If you are closing in on retirement, you likely will want to readjust your risk profile towards something more conservative. But, once you choose a model, stick with it for five years unless your life changes dramatically.
For those looking for general portfolio guidance, Sam Dogen discusses three ways of determining asset allocation in his WSJ best-seller, which I recently read: Book Review: Buy This, Not That. I found his examples helpful and have used two here.**
Example one involves subtracting your age from a hundred; the remaining number equals your suggested stock exposure. That would mean investors aged fifty would have 50% of their money invested in stocks and the remaining 50% in bonds.
Example two involves subtracting your age from one-hundred-twenty; the remaining number equals your suggested stock exposure. That would mean investors aged fifty would have 70% of their money invested in stocks and 30% in bonds.
Using these two different allocation models, you can create a range of potential exposures to stocks and bonds for your age. Those fifty years of age should consider utilizing equities for 50-70% of their portfolio and the remaining 30-50% in bonds. Still, this general guide must be catered to your desire for gains while observing the potential for losses; everyone is unique!
Remember: selling during a crash is the most egregious judgment an investor can make. Therefore, if you cannot stomach a potential loss, you cannot expect that level of gain.
*A 78% allocation to international stocks stems from a proportional global market capitalization investment strategy, which Vanguard discusses. Currently, the US economy represents ~22% of the world economy.
**Sam’s quick calculation guides don’t provide cash and cash equivalents allocations. My suggestion is never to keep more cash on hand than needed. For retirees, this could be one year of living expenses. For savers, this could be an emergency fund and any large purchases that are imminent.
Concerning volatility and risk
Investment professionals often describe risk in terms of volatility, but for the layperson, that means little.
Volatility when investing refers to the range of returns one can expect when investing. The greater the volatility quotient, the greater the variance m an investor can expect to yield yearly from the average.
Intriguingly, volatility refers to both positive and negative returns and doesn’t differentiate between the two. Instead, it just measures how variable returns are from year to year.
Hence, the more consistent an investment, the safer it will generally be for investors. As an aside, wouldn’t you agree love is partially about consistency?
The chart above shows that stocks are much more volatile yet return the most. Concurrently, cash equivalents almost always yield small amounts, but they tend to be very consistent.
If you ever see a volatility measure of your portfolio and the number is in the double percentage digits, understand you can have a wide spread of returns.
Closing thoughts on risk
There you have it, risk and return — the yin and yang of the investment world. I hope that you have found this guide easy to understand and instructive so that you can better prepare yourself for times of economic turmoil.
Risk is something that should be top of mind for every investor. Otherwise, they will be singing:
Have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time