Risk is an inherent part of your stock investment portfolio, and lately it’s been paying off. But that risk has a downside, too. Keith Akre, of Stillman Bank, explains.
Investment returns in 2019 were outstanding. At the end of November, the S&P 500 was up 27.63% for the year. Even the relatively more-conservative bond investments had strong returns, as the Barclays Aggregate Bond Index had gained 8.79% during the same period. With gains like these, it is easy to get complacent. Why mess with something that isn’t broken?
The problem is that many investors do not pay enough attention to the risk they are taking in order to get the returns they do. It is one of the rare iron rules of finance that you cannot get additional return without assuming greater risk. For most of the past 10 years, taking risk has been well rewarded. History tells us that will not always be the case.
What can the average investor do?
First, you should get a gauge of the risk in your current investments. Risk is most commonly measured by standard deviation – the average percentage variability above or below an expected return. Your financial advisor should be able to give you an idea of what that value is and how it compares to the market overall. If you are a do-it-yourselfer, you can still get a decent gauge on the risk of your investments without having to pull out your old statistics textbook.
Just look at your overall asset allocation and see how much is held in risky investments compared to safer ones. The chart on this page is a good starting point for the relation between risk and return.
To make it even simpler, just recall that in the financial crisis of 2008, the S&P 500 dropped by 50% from top to bottom. Therefore, you can use that figure as a “worst-case” scenario to stress-test your portfolio. Just imagine that whatever percentage of your investment portfolio is held in U.S. stocks has the potential to drop by 50%.
Using this rough rule of thumb, if you have half of your investments in U.S. stocks and those stocks drop by 50%, that would equate to a total drop on your investments of 25%. Would your financial goals be at risk if your $1 million nest egg was reduced by $250,000?
Someone with a long-term time horizon might not be. They would have the time for markets to recover, and actually be able to take more risk. However, if you are currently in, or getting close to, retirement and will require distributions from investments to cover expenses, you may need to reduce risk. As always, talk to your financial advisor before making any investment decisions, as every investor’s circumstance is unique.
The bottom line is that, while we have enjoyed a very good year of investment returns, we cannot expect the next one to be as kind. For 2020, smart investors will focus on the risks in their investments and make sure they can weather any kind of market with all their future plans securely intact. Get the new decade started off right: complete a risk assessment of your portfolio, make changes if necessary, and gain confidence in the staying power of your investments.