Emotions and Investing: The risk of not taking enough risk
By: Joe Thomas, CFA
Competent Investment Professionals would agree that market timing to hedge risk is not an appropriate long-term strategy. We’ve also discussed in this blog that the biggest determent to individual investors, even those receiving advice, is making investment decisions in an emotional state (euphoric or despondent) or simply put making long-term decisions based on short-term expectations. We’ve started some discussion on understanding these things and investing with an awareness of how we react in those emotional states.
It’s easy when emotions, savings, and investing can all balance out in a pleasing state, where you can take a risk you are comfortable with because you are saving enough or not spending too much. In a perfect world, a person not comfortable with stock market gyrations could invest in a portfolio of conservative non-market assets and meet his/her goals. Unfortunately, often things cannot balance out that easy. We know lower risk coincides with lower return and it is tough to save enough to accomplish your goals with the returns offered on conservative fixed income investments.
Consider an average retired couple, they’ve been told withdrawing 4% is a conservative way to spend during retirement. They are very risk adverse and know emotionally seeing portfolio losses, even moderate make them uneasy. Four percent doesn’t seem like an unreasonable amount to earn, a diversified bond portfolio should average that over a 30-year retirement. What they are failing to factor in are all the extras mainly; inflation and fees. Assuming inflation runs at 3% and fees are 1%, someone withdrawing 4% would need to earn between 7% - 8.20% (depending on method of calculation). Even if inflation and fees are a bit lower, they still would most likely need to add some risk assets to meet their long-term goals.
More often these are the typical scenarios, where we cannot have an exact match between a combination of risk assets and savings/spending that we are emotional comfortable with. At this point we must make some decisions on what we are willing to sacrifice, spending or comfort. These investors could avoid stock market volatility with a portfolio of bonds, but as they age this likely begins to become a problem as inflation and fees reduce their principal. Adding some risk assets over the course of their 30-year retirement should make accomplishing their goals much more probable, but it also makes the ride much bumpier. Unfortunately, if they decided or were advised to a portfolio of conservative fixed income investments, the problem wouldn’t start to be noticed until years down the road when the clients have aged and likely have limited earning power.
You could make a similar assessment for someone younger and in savings mode. Assuming you aren’t ultra-wealthy already; looking at your income, current spending, and potential spending in retirement you are going to need to take some risk.
Most of us need to take some risk with our investments to accomplish our goals, balancing your emotions by taking a long-term prospective is most beneficial. But occasionally the seas will get rough and abandoning your investment plan is never a good long-term strategy. Every investor will experience at least a few bear markets in their investing lifetime and should have a plan that does not require making investment decisions during times of market stress.
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Investing involves risk, including the potential loss of principal.