The current bull market that started in March 2009 is the longest bull market in history. I frequently get asked questions about how long it will last and how big of a drop we can expect when it goes the other way.
Unfortunately, no one knows the answer to that question. Instead, you should be asking, “Am I invested where I’m supposed to be?” This question is important because it can help determine the true impact to your portfolio when and if the market falls again. The answer to the question lies in several other questions relating to your risk tolerance.
Risk tolerance is the extent to which you are willing to accept greater risk of loss in a portfolio in order to potentially receive a higher return on those assets. I don’t believe that a risk tolerance questionnaire is an adequate measure of how a person truly feels about risk. I always ask a client, would you answer a questionnaire for risk tolerance in March 2009 the same way you would have in September 2007? Of course the answer is always no. After a massive market decline, few people feel they have the same risk tolerance after that time period. For this reason, a questionnaire lacks accuracy. The answers to these questions will give you a much better perspective.
1. What is your time horizon? This is by far the most important component to look at first. 2008 to a record high was 5 years. When looking at your investments, you should ask yourself, “Do you need this money in less than 5 years? More than 10?” Sometimes when I’m asked about market drops, it’s from people in their 30s regarding their retirement accounts. For them, they have a longer time horizon to potentially recoup their losses. Contrast that with a retiree who may be living on the earnings from the investment account, and you have two very different answers to the risk tolerance question. If you have more than 10-15 years until you need the money, it’s hard to make the argument to invest conservatively, unless you simply can’t sleep at night knowing it can fluctuate. Part of the time horizon conversation includes your life expectancy. As planners we tend to assume longer life expectancies because it is considered more conservative planning to do so. Often however, a person or couple in poor health might be unrealistic in assuming a 30 year time horizon.
2. Sleep at night factor: As mentioned above, can you sleep at night if you know your account could drop 30% to 40% in the next 12 months? You can have all the time horizon in the world, but if you’ll be stressed out every waking moment of the day then it will certainly factor into your overall risk tolerance. I will often give new clients a scenario of a 40% drop in account value by our next annual meeting. I ask how they will feel about seeing that and discussing its impacts to determine their risk tolerance.
3. Other investments and income sources: What other investments and income sources do you currently have? Do you receive a pension and Social Security? Does your spouse? If your fixed monthly income already covers all of your expenses, then you theoretically have a higher risk tolerance than someone who depends on the investments themselves to supplement income. That said, some investors who know they have all the expenses covered already don’t need to take a lot of risk because they don’t need the investments to “work” as hard for them.
4. The make-up of your investments: Is the portfolio highly concentrated in only a few stocks? What is the predominant make-up of the investments? Is it all in Large-Cap growth? International? U.S.? The more diversified an equity portfolio is, the better the chance it can potentially minimize losses in a declining market. I use the parachute theory. The bigger the chute the slower the fall, so spreading out the investments wider in a volatile market may help minimize the impact of a market drop.
5. Other considerations: Sometimes there are other factors that affect risk such as the likelihood of an emergency for needing money that they never intended to touch.
Getting the answers to these questions goes much further to access a client’s risk tolerance than a standardized questionnaire. I will usually go a step further and try to reframe the questions a different way to see if a client will answer the same question differently. I’m aware that some clients may at times answer a question the way they think I want them to respond. Meaning they know the "right" answer even if it doesn’t accurately reflect how they feel about the risk.
It all comes down to truly getting to know your client and what’s important to them. It’s not always easy to figure out at first when investing the money, but in time, it will become more apparent when you begin to see different market cycles. The way I usually handle that is by suggesting a slightly more conservative investment than the client's risk tolerance at first indicates until they have had a positive experience or been through a market change. Once we know how they react, we can begin to alter the risk up or down as necessary.
T. Eric Reich, CIMA, CFP, CLU, ChFC is president and founder of Reich Asset Management and can be reached at 609-486-5073 or email@example.com.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.