Wise investors focus on value when evaluating investment options. Too many investors focus on buying market trends and economic outlook, not realizing that trends can be deceiving and markets often perform very differently from the economy. Individual stocks can easily surprise you – rising in a down market, and falling during a rally – making it important for long-term investors to focus on buying quality investments with good fundamentals.
While economic trends can exert a powerful effect on market movements, the stock market and the economy do not move with perfect correlation and there are many occasions in which markets rally in spite of poor economic fundamentals or declining corporate earnings. This is not to say that economic outlook is unimportant. A smart investor keeps an eye on the economy and factors economic outlook into investment decisions, but ultimately seeks high-quality individual investments.
Investors do best when they take on the right amount of risk for their individual goals and tolerance. Too many investors focus strictly on generating returns while ignoring the importance of managing risk properly.
Too much risk can leave your nest egg vulnerable to market swings with too little time to recover before you must start withdrawing money and locking in the losses. Too little risk in your portfolio will reduce your potential for capital appreciation and allow inflation to eat away at the long-term value of your investments.
The challenge is determining how much risk is right for you and your portfolio. Knowing your risk tolerance and the appropriate amount of risk for your investment goals is one of the most important concepts we discuss with our clients.
No one wants to see their portfolio lose money, but it’s important to understand that an investor must take on more risk in order to achieve higher long-term returns. It’s vital to be honest about your ability to withstand short-term swings in value and accept reasonable investment losses in the pursuit of returns.
Another essential question you must answer is how much risk you need to take in order to meet your investment goals. Modern portfolio theory hypothesizes that there is an asset allocation strategy that will generate the highest return for every risk level. The right risk allocation for a portfolio will depend on a number of factors, including your expectations for return, investment objectives, time horizon, and appetite for risk.
Many popular asset allocation tools focus on age – or time until retirement – as the primary driver of an allocation strategy. While this can be useful, age is only one factor in determining a proper asset allocation strategy; other factors include liquidity needs, net worth, and investing priorities.
On the face of it, the logic of decreasing allocation to equities and increasing fixed income holdings as one gets older seems reasonable. As investors approach retirement, their ability to wait out portfolio swings or earn their way out of losses diminishes. However, many age-based allocations fail to adequately account for longer life spans and the effects of inflation, putting investors at risk of running out of money later in life.
Ideally, you should be allocating your investments based on your investor policy statement (IPS). Your investment plan should be based on the return you annually need to achieve so you can meet your financial goals by a set date in the future.
This is called the required rate of return, or RRR. Assuming you calculated the cost of your retirement years (the number of years you’ll be in retirement, the events and activities you want to enjoy, the taxes you’ll pay, the cost of inflation…), you can now reverse-engineer the calculations to tell how much you should be investing, at a specific annual percentage rate, from now until retirement…while being cautious not to exceed undue risk.
Not everyone knows how to do this. In fact, typically only good financial planners, such as a Certified Financial Planner® (CFP®), can do this.
Ultimately, holding the wrong amount of risk means you may not realize the investment gains you expect or you may experience wider swings in your portfolio’s value than you can stomach. If you are unsure about the current level of risk in your portfolio or have questions about risk management, it may be worth speaking with us. Our experienced financial advisors can help you understand the best options available to you.
Your financial goals are our priority. We start by listening to your plans for the future, and then set your dreams into short, midterm, and long-term goals. We then create a financial plan to achieve your goals, and monitor and manage your customized financial plan for steady but cautious growth, loss protection, limited taxes, and estate preservation … assuring your financial future.
We hope this article about investment principals was informative. Please contact us so we can review the possibilities for securing and increasing your personal wealth while enhancing your retirement. Thank you!
Joseph M. Maas, CFA, CVA, ABAR, CM&AA, CFP®, ChFC, CLU®, MSFS, CCIM