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Risking Risks

By Richard Tomes April 12, 2017 Market Watch

Rising Risks

 

To some observers it seems that risks are rising for the stock market.  Some of these risks are:  1) Rising Interest Rates; 2) Geopolitical Events; 3) High Valuations; 4) Legislative Action or Inaction; and 5) a New Administration.

 

In reviewing that list, one might ask, “So what’s new?”  On the list, the only one that really seems new is that we have entered a period of expectations for rising rates.  There are always geopolitical events and sabre rattling of one sort or another.  Stock investors are constantly concerned about valuations.  Congress seems as inept as usual.  New administrations come every four to eight years, so that is regular.  When the last administration took office there was a lot of angst and uncertainty then, too.  Though, perhaps, by different people than at this time.

 

While the risks are not new, many seem to be concerned that that the probability of one of those risks getting out of hand is rising.  An article just came out today (April 11, 2017) in an industry journal that states that US bond mutual funds took in more new money last quarter since 2012.  Bond funds often attract money from nervous individual investors.  Using that as a gauge, it would seem sentiment is that bad things are to come. 

 

Often, popular sentiment proves inaccurate.  While concerned individual investors put a lot of money into bond funds in 2012 as they worried about the future, 2013 turned out to be a very good year for the stock market as measured by the S&P 500, which, on a price basis, was up 30%.

 

What to Do When Perceived Risk Levels Rise?

 

The wise thing to do before beginning an investment strategy is to determine logically what that strategy should be.  For most individuals, that strategy is often derived from comprehensive financial planning.  Through the planning process, a portfolio strategy is chosen that combines targeting needs, present and future, determining the growth needed to achieve those targeted needs, then putting assets not needed to grow to hit those targets into less volatile, more stable and predictable assets, such as bonds and cash.

 

Assuming one’s portfolio strategy is logically derived and understood, here is what may be done when it is perceived that risks are rising.  1) Review the planning documents that led to the portfolio strategy.  2) Review the goals and targets.  Has anything changed?  If so, then it is time to review and potentially update the plan and strategy.  If not, then the overall strategy should still be appropriate, including its volatility parameters.  3) Approach the perceived risks without thinking about the portfolio and what might happen to its value.  Try to take any emotion of how it might affect you personally, and review the risks logically.  What are the various factors, potentials and outcomes of the risk?  4) Once one is certain it is not just emotional fear related to money that is causing fear, but actual factual data indicates the rise in the risk, it is time to turn to tactical considerations.

 

Tactical Considerations

 

Sometimes the strategy is sound and good.  However, the risks may justify some temporary changes.  The tactical changes should not be dramatic, but subtle.  Remember, the strategy has been chosen for a reason.  For example, someone who has a 35% bond, 60% stock and 5% cash portfolio may choose to reduce stock exposure, if the risk is seen to be to stock prices.  That individual should likely not go to 30% stocks.  The reason is that timing the markets and trying to guess has been shown to be very difficult indeed.  In the present discussion, the flight to bonds in 2012 proved to be bad timing, as 2013 was a very strong up year for stocks.  The long-term strategy depends on the investor participating in stock markets in both good and bad years.  Very often, it is only a few days in a year that lead to strong upside and if one misses those days, the returns suffer substantially.

 

Generally, a good tactical decision would be to reduce stocks in the hypothetical allocation given by about 5% to 55% in favor of cash.  Then wait a month and return to tactical considerations.  If risks have risen even higher, it may be wise to remove another 5% to 50% and wait another month.  This is likely enough.  For the 10% removed from stocks is actually a reduction of over 16% stock exposure.  Remember the reduction in stock risk was based on the total portfolio.  Stocks were only 60% of the portfolio, so removing 10% from the portfolio allocation is removing 16.66% from the stock allocation.  This may be a good compromise, allowing for participation in any surprise upside that would be meaningful, but reducing risk appreciably.

 

Should the conditions persist without resolve and it should seem that will continue, then one might consider adding the 10% cash raised to bonds for a time.  When conditions seem to be turning, the reverse operation may be wise.  Add 5% back into the stock portion of the portfolio, then wait a month and revisit.  Then, if deemed appropriate, add the other 5% back into the stock allocation, brining the portfolio back to strategic targets.

 

Should the risks perceived be realized and a sharp drop in the stock market occurs, then it would generally be wise to add funds back to the stock allocation.  Half first and then the rest a few days or weeks later could be wise.  Should the decline be substantial, it may be a good idea to add to the allocation by selling some of the bond allocation to tactically overweight the stock holdings.  Again, a 10% variance should generally be a good tactical limit.

 

Emotions

 

Emotional decision making seldom works with investing.  Pilots know how hazardous it can be to fly on feelings.  Often a pilot may feel things that are different than what the instruments are telling.  Experience tells the pilot to ignore the feelings and follow the instruments instead.  As a famous example, the investigators concluded that JFK, Jr. became confused and disoriented because he was not paying attention to his instruments.  It seems he was busy looking outside the cockpit trying to see the airport.  While looking out the window he was ignoring the instruments and flying as he felt was right.  We know the tragic consequences.

 

If an investor, through sound planning, has devised an appropriate strategy, the investor may take comfort in knowing why the allocation is what it is.  That investor understands that the ups and downs in the markets were taken into consideration in the strategy’s design.  The investor may take comfort in that knowledge, realizing that there are always risks.  Knowing the why goes a long way to checking emotions and easing nerves.

 

Managing risk is more than just overall, broad allocation.  At TWPM we work diligently to attempt to help our clients take as much risk as is necessary and prudent, while trying to avoid taking more risk than necessary to reach an acceptable probability of achieving targeted goals.  This goes beyond stocks, bonds and cash and looks to offset certain risks with sector allocation, credit allocation, tactical movements, hedging where appropriate, etc.

 

No matter how much one tries, sometimes emotions still can overtake each of us.  It is okay.  It is human to become concerned and even nervous at times.  We are here for you, our clients, and invite you to contact us any time you have concerns, are nervous or worried about risks.  We are here to help you analyze and evaluate your strategy in light of current conditions and will help you adjust as needed.  It is a pleasure to serve you.

 

Cheers,

Richard Tomes, CFP®

President

Total Wealth Planning and Management, Inc.