Most of us know that there are risks when it comes to investing in the public markets and that we should build our investment portfolios within a general level of risk. We take risk questionnaires and use prior life experience to classify ourselves as a conservative, moderate, or aggressive investor (or somewhere in between.)
But what does “risk” really mean?
Traditionally, most asset managers and financial advisors use the term “volatility” or “standard deviation” to define risk. Both of these terms refer to the amount of short term price fluctuation an investment is expected to experience.
The more the price of an investment goes up and/or down, the higher the volatility/ standard deviation, therefore the “more risky” the investment is.
Although this is all statistically accurate, we think the biggest risk for most investors is a bit simpler- not achieving your financial goals.
Think about it like this: in your retirement portfolio, is the biggest risk:
- short term price fluctuation or
- in one way, shape, or form, for whatever reason, you won’t have enough money to retire comfortably
Now, hopefully, we are starting to focus on what really matters.
The next step is to ask yourself the following question:
“On a scale from 1-10, 1 being the expected risk and return of cash and CD’s, and a 10 being the expected risk and return of the S&P500, where would you say you are? Knowing if you say a 10, you will get all the ups and all of the downs of the S&P500.”
This is one of the questions we ask our clients that allows us to look at risk differently. We are essentially finding out how much the boat can rock before you want to call it quits.
We take this number and we pair it with a term called Beta.
In our assessment, Beta shows how closely an investment moves up and down with the S&P500. An investment with a beta of 1 will move identically with the S&P500.
Going back to the 1-10 questions, if you say you are a 6, we build your portfolio to have a Beta of 0.60. This allows us to define risk more precisely and track it over time so we both know where you sit in terms of risk. (A little better than “moderately something”, right?)
But remember, the biggest risk is that you don’t achieve your financial goal. So this conversation about risk is useless without a financial plan.
We need to know where you are and where you want to be. By looking at it this way, we can identify how much money you need to earn on your investments to get you from A to B. We call this your target rate of return.
Based on your target rate of return and how you feel about moving with the ups and downs of the market, we can now determine:
- whether or not your goals are realistic and
- how to go about investing your money in a way that’s designed to help you reach your goals and keep you invested along the way.