Risk Tolerance, Asset Allocation & Rebalancing...what are they and why do we care?
Let's start by getting out of the terminology and into understanding how we are impacted. First of all, Risk Tolerance, to very simply dissect, think about this as your willingness or ability to tolerate risk in exchange for a perceived reward. Have you ever heard, “The greater the risk, the greater the reward”? At face value, sign me up. I’ll take the reward, i.e., higher returns and more money to use toward my goals at the finish line. However, we’re missing the RISK that we are willing to accept.
The last month and a half or so in the market, that risk might be feeling a little less appealing than in did in 2019 when we had a nice little recovery after the market adjustment the last few months of 2018. Seeing a 30% return in an aggressive account in 2019 was rewarding…there’s the reward part. However, if seeing your account net negative when averaging 2019 and 2020 year-to-date is keeping you up at night, you might not have had quite the appetite risk that you thought you did.
I often tell my clients that their Risk Tolerance is truly defined by times when the market is not playing nice. So, gut check…how have you been feeling about your account values these last several weeks? Investing is a long-term play, the market goes up…the market goes down. However, historically, the general direction has been up. When you're thinking about your Risk Tolerance, I would challenge you to consider several factors:
- How long is your long-term game? That is, when do you anticipate needing the funds from said investment?
- What is your life situation? Are you a dual income/dual investment household or is everything dependent on you and how your investments perform?
- What is your ability to ride out a storm in the market? Do you have other income streams or sources of funds to use in the event that taking from your investment accounts in the short term would lock in or realize the losses incurred at that particular point in time?
- How do you feel about the market when it is down? While feelings are difficult to quantify, if you are tempted to pull all of your money out of the market when conditions are unfavorable, there may be other strategies, such as a Fixed Indexed Annuity (future post to come and, call me if you have questions as this solution is not appropriate for all investors).
Asset Allocation, the old “don’t have all your eggs in one basket” adage. Question is, how do you know what to invest in, how much to invest in each place and whether you have an appropriate investment mix for your specific Risk Tolerance? Please, use an Advisor. There are a plethora of resources available for those who are interested in DIY projects…I would contend that your financial future should not be a DIY project. A comprehensive financial plan is so much more than where you put your money, as a Financial Advisor, I want to be the Quarterback of your financial team. I want to work with your CPA (tax preparer) to figure out a tax strategy for your unique situation and work with your attorney to help ensure that your end-of-life estate plan is flowing through your financials appropriately. Your financial professionals need to communicate or work through you to communicate or they may all have strategies that do not align to serve you cohesively.
Ok, back to Asset Allocation. An Asset Class is a type of investment, some times specifically investments in the United States or overseas, sometimes in stocks vs bonds, sometimes with we are specifically giving whomever is managing that pot of money more flexibility to decide how to best invest that money over time. The amount of dollars or percentage of your assets that you put into each Asset Class should be dependent on your Risk Tolerance….see the consecutive flow here?
Working with a Financial Advisor to determine your Risk Tolerance should directly feed into making sure that your Asset Allocation is appropriate for your financial situation and goals.
Rebalancing, the name is self-explanatory, so why are we taking the time to discuss it? Well, just as it sounds rebalancing is periodically moving your investments back to the Asset Allocation that is appropriate for you based on your Risk Tolerance…a big circle, just like the pie chart of your investment mix. Simple as it sounds, you and I are both human. And, by nature of our humanity, there may be times when as your Advisor, I ask you to sell some of your winners and buy some of your losers. Sounds crazy, right?
Let’s say, hypothetically, that coming out of the COVID-19 pandemic, international stocks, mutual funds and other related investments soar the following year as part of a recovery. Let’s say that said investments outperformed everything else in your hypothetical portfolio. Now, as a result of a nice recovery, your Asset Allocation now includes 32% in international investments instead of the desired 21%. Great, right? We’re so grateful to see positive returns in our portfolio that we want to keep riding rocket as far as it’ll take us. Here’s the problem, if something happens internationally thereafter…you now have a much larger portion of your pie than is really appropriate for your Risk Tolerance exposed to international markets. As a result, you could see a greater decline than you'd otherwise expect by not rebalancing your accounts periodically.
We’ve covered a lot in this post. So, here are a few key takeaways:
- Risk Tolerance and Asset Allocation should not be a DIY project, I would suggest working with a Financial Advisor to help make sure that your investments are appropriate for your situation as well as adjusted over time according to your evolving age and life goals.
- Rebalancing really matters, try to stay objective, emotional decisions related to your investments generally do not serve you well.
- Call me with any questions about Risk Tolerance, Asset Allocation and Rebalancing, I’d be happy to help decode your situation.
This is meant for educational purposes only. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions. Generally, the greater an investment's possible reward over time, the greater its level of price volatility or risk. Keep in mind that rebalancing may have tax consequences and transaction costs associated with this strategy. Please consult with your tax advisor regarding your personal situation. Asset allocation is an investment strategy that can help manage risk within your portfolio but it does not guarantee profits or protect against loss in declining markets. Investing involves risk, including the potential loss of principal. Past performance is no guarantee of future results.
(04/20)