The original version of this article was published November 15, 2004 under the title “Retirement Wisdom Part 4 – Adjust Risk Appropriately.” Time-sensitive numbers are relative to the original post date.
When the market is doing well it seems as though investing is strictly about the wisdom of knowing where to plant, when to water, and having the patience to wait for it to grow. But in fact in both good times and bad times, investing is really about managing your emotions. If you want to be an investor, you have to grow to understand not only the relationship between risk and return, but also your own reaction to it.
There are four deadly sins that will keep you from managing risk appropriately: ignorance, greed, fear and pride.
Many investors don’t understand emotional risk or they choose to ignore it. As a consequence, many have made significant financial mistakes.
By mistake, I don’t mean losing money. We all make those mistakes. It isn’t necessarily a mistake to make an investment and loose money on it. There is no risk looking backward, only looking forward. Risks must be taken, but there are some risks that are foolish even if they don’t make money. These mistakes are actions where the emotions of greed, fear, or pride cause us to fail to act according to our values and goals.
Greed pushes us to concentrate in investments with the possibility of large returns without determining if that is the best path to meeting our financial goals.
During the last few years of the technology bubble, many investors were taking money out of growth funds to add to their aggressive growth funds in order to make even more money. At the height of the markets they were invested exclusively in the most volatile large cap growth investments possible. One investor thought they were diversified because they owned six mutual funds each whose primary holding was Cisco. When the markets finally corrected those investors lost 80% of the value of their portfolios.
In 2000 when large cap growth stocks crashed 33.5%, small cap value gained 18.7%, and in 2001 while large cap growth dropped an additional 19.1%, small cap value was still going up and gained another 18.6%. The stock market bubble was almost exclusively a large cap growth bubble.
Diversification away from large cap growth does not mean sacrificing good returns. In fact, value and small cap funds have historically out-performed large cap growth funds.
Over the past ten years, large cap value has averaged 10.29% over large cap growth’s 8.01%. On a $10,000 investment, the difference in returns during the decade is over $5,000.
Small cap value over the past decade has averaged an even higher 13.75% return. During the past ten years a $10,000 investment in small cap value appreciated nearly $15,000 more than large cap growth.
Many attempts to increase your average return may actually decrease the chances of fulfilling your financial goals.
Stocks in the technology sector have the highest average monthly return at 1.43%, but they also have the highest volatility. Stocks in the healthcare sector, on the other hand, have the second highest monthly return at 1.40%, but their volatility is one of the lowest. Diversifying your portfolio between all the categories that do well historically and over-weighting those that do well with less risk can provide a measure of stability.
The risk of owning stock is volatile enough. The risks of other investments such as commodities, options or private placements are less appropriate for retirement planning.
For example, one younger wealthy client thought that a $25,000 investment of venture capital money was an amount that was small enough to lose without effecting their retirement. They were willing to risk the immediate loss for the possibility of wild returns. But any investment that is not publicly traded is a very risky venture. At conservative returns of 8% for fifty years, a $25,000 loss results in over a million dollar smaller portfolio. The immediate loss is tragic because of the lost opportunity for more likely growth in the markets.
Get rich quick schemes never work. Neither does giving up too easily. Successful investing simply follows the balance of these two maxims. Without that balance, fear can drive us away from investments with a good historical return.
One common mistake during retirement is to emphasize interest and dividend payments over growth in the portfolio. Portfolios at any age need a component of diversified growth in order to keep up with inflation.
Another common mistake during retirement is to believe that a large fixed income component can better weather a down turn in the markets. When the stock market suffers a loss, portfolios with a smaller stock percentage are hurt less, but they are also less able to make up that loss in future years. If the goal is to decrease your chances of running out of money, an all bond portfolio has more risk of running out of money.
Being conservative during retirement doesn’t necessarily mean settling for lower fixed income returns. It starts with being conservative with the amount you are withdrawing in order to ensure that your money will last your lifetime with an ever-increasing standard of living.
Pride makes us want to have done better than others no matter what risks were taken.
We want to beat the S&P 500. We want to surpass our projected goal. And we want to have done better than that obnoxious person at work who is always bragging about their investments.
It takes a spiritual compass to keep these sins in check and follow an investment philosophy. A conviction that we should be stewards of our resources provides a worldview that curbs our emotions and frees us to simply invest the money as we deem appropriate to best meet our designated goals. Within a spiritual framework we can lose money on our investments but still have acted in a virtuous way.
Managing the money is easy; managing the emotional experience of purposefully exposing your finances to hope of gain and the risk of loss is the hard part. Risk is much more than just quantitative numbers. Risk is about understanding your own greed, fear and pride.
Photo by Elijah Hail on Unsplash