“If you don’t know who you are, the stock market is a very expensive place to find out” Adam Smith, Author of “The Money Game”
In our January commentary “Ignore the Scary Headlines and Stick to Your Plan,” we discussed the core principles that we employ in constructing portfolios, and specifically how we attempt to control risk. We felt that it required a follow-up:
Assessing your tolerance for risk
There are two parts to answering this question: the risk you need to take, and the risk that you are willing to take.
The first part of the process is determining how much risk is required for you to meet your goals. Think of risk as a dial. The more you turn it up—by raising the percentage of stocks in your portfolio, the greater the potential future returns. Then the question becomes: given your current portfolio size and anticipated saving rate, what annual return do you require on your investments in order to reach your goals? To illustrate, let’s take the example of a 50-year old woman with a $1.5 million portfolio who saves $10,000 a year, wants to retire at 70, and who estimates she’ll need $100,000/year once retired. We estimate that her portfolio would need to earn 2.5%/year (net of expenses) over the next 20 years. Such a rate of return could be achieved with a small allocation to stocks, say 30%. On the other hand, if the same investor needs $200,000/year at retirement, the portfolio would need to grow at 6% a year to meet her retirement goals (or she would need to save more aggressively). Based on historical data, 6% can only be achieved with a high allocation to stocks (70%) and a significant amount of downside risk. Although different practitioners might recommend different percentages, the relationship holds. The higher your personal required rate of return, the higher the percentage of stocks and the higher the risk.
The second part is determining how much downside you are willing to take without feeling so stressed that you’ll end up liquidating your investments in the midst of a market decline. Bear markets will test your prior resolutions. At Bristlecone, we believe that how you felt AND reacted during prior bear markets is one of the more reliable indicator of your willingness to accept risk. But we don’t want to rely solely on how you feel during volatile times. We also take into account how you’ve dealt with financial risk in other areas of your life: Did you start a business? Do you carry a big mortgage? Did you invest in private partnerships? Finally, we realize that circumstances change over time, and that most people become more conservative as they grow older. So history should not be the only guide.
All of our clients need to accept some degree of downside risk to reach their goals. In our regular discussions, our objective is to help them find and constantly reassess the right amount of risk that will allow them to reach their goals without deviating from their long-term plan at volatile inflection points. .
Keeping tabs on what matters
At Bristlecone, one of the things we work hard at every day is culling the “noise” from our decision-making process. We don’t spend our day watching “info-tainment” cable news shows where pundits offer competing short-term forecasts on stocks or the broader economy. Rather, we spend most of our time scrutinizing primary source documents such as SEC filings, trade magazines, and industry newsletters. These latter sources facilitate a more rational, dispassionate investment process, oriented toward maximizing long-term investment success. The same idea applies to our clients: focusing on the right information leads to better, more rational decision-making. For instance, if you’re already retired, be sure to watch your spending, and keep enough cash and high quality bonds (we typically recommend 3 to 4 years of net spending) to weather the inevitable stock market declines. If retirement is still a few years away, keep tabs on the amount you need to save for that purpose.
Finally, no matter what the goal is, keep track of your long-term absolute investment performance. At Bristlecone, we believe in transparency. We show market benchmarks in the reports we compile for our clients every quarter, so that they can assess their portolio’s relative returns. However, we consider this a secondary measure of your investment performance. The primary one is not on your report: it is the previously discussed personal rate of return needed over time so you can retire on time, afford to send your children to a college, or fund a charitable foundation. We select investments which we think will have a high likelihood of outperforming their respective market benchmarks over time. However, it is your personal required rate of return which should be at the forefront of your thinking. So long as your overall portfolio is meeting this return objective over time, you should not become overly distracted with bear markets or variances in return of the underlying asset classes.