Portfolio Management Q & A

Q:  How do I know if I am taking the proper amount of risk with my investments?

A:  There are several ways to indicate how much risk you should be taking with your investments.  The problem is none of them are perfect and some are contradictory, since everyone desires high returns with no risk.

1) Initial Risk Tolerance Questionnaire (The Starting Point) This questionnaire is designed to find out a number of things about you as an investor.  Some can be quantified, such as when you will begin taking distributions.  Others ask you to be introspective and question how you will respond if certain things happen in the marketplace like a large decline.  Lastly, the questions attempt to find out how you will try and make trade-offs between risk and reward.

2) The Financial Plan The financial plan is designed to assess your goals and to ascertain how your cash flow, future savings, and current assets may be able to help you meet those goals.  If a high rate of return is necessary to help meet your goals, then it may be necessary to take more risk in order to have a chance to achieve those goals.  Conversely, an abundance of resources to meet the goals may indicate that a conservative portfolio would be sufficient.

3) Investor Experience & Behavior This is the most important factor in determining your true risk tolerance.  If the original questionnaire is designed to find out what you think you might do in a given situation, then your actual experience and how you behaved is the ultimate proof and becomes the overriding factor.


Q:  What investment behavior do you look for in re-assessing my risk tolerance?

A:  Any behavior that forces a change in how the investments are managed.  The most common is a reaction to market losses.  In the most extreme cases it involves the investor wanting to sell all of their risky assets and move to cash.  In nearly all cases it involves the need for the emotional reaction to create action.  It is fine for investors to feel this way.  In fact, we all have our breaking point at which we will question the methodology of how we were investing.  For some it can be a loss of a few percent in a quarter, while others can withstand a great deal of pain as demonstrated by the fortitude of many investors maintaining their investment process through the last decade.

Changing investor behavior can also come from the feeling some people get when they feel they are missing out on high returns because they own too many conservative investments.  Ultimately, the balance is created by an investor feeling confident most of the time and occasionally feeling like they are taking too much risk and sometimes feeling they are missing out on stock market returns.

Q:  If it becomes apparent that a change in risk is necessary or inevitable, how is that appropriately handled?

A:  Because we are trying to find equilibrium between risk and return, incremental changes and observation are the most effective method.  As an example, assume that a recent market drop brought about a realization that the current portfolio was too volatile for an investor.  The common emotional response is to shift entirely to a conservative portfolio.  The difficulty with this response is that the portfolio is now undoubtedly too conservative and further removed from the suitable balance of risk and return.  A more reasoned response would be to lower the risk level by decreasing the equity percentage by 5 or 10% and then re-evaluate from that point.  This is analogous to setting the thermostat in your home.  If it is 90 degrees, you dont want to lower the thermostat to 50 degrees to cool you down, you only want to lower it to a level you believe you will be most comfortable.  Otherwise, you risk becoming too cold when all you are trying to accomplish is not being too hot.

We plan for this through an evaluation of the type of market conditions that brought about this realization and make a decision about which type of portfolio is appropriate.  Typically, this involves a shift to the next least (or most if a more aggressive posture is needed) risky portfolio.

Q:  Is there a set amount of risk to take?  Can you be too conservative or too aggressive?

A:  There are some measurements that can indicate certain risk levels, but they are largely independent of the investor.  Most of these measure the change in the amount of return for a change in the level of risk.  Ultimately, these are useful tools, but should not be taken as the primary method of determining how much risk is appropriate for you.

However, it is possible that being too conservative or too aggressive may not be the most prudent approach for the vast majority of investors.  Aside from the willingness to take risk, the trade-off between risk and return becomes exaggerated as we move to the extremes of 100% equity or 100% cash and bonds.  In the middle of the spectrum, the trade-off between risk and reward might be an increase of 3% in standard deviation (measurement of risk) equating to seeking 1% in return.  As you move toward the more aggressive end of the spectrum, the trade-off might be 5 or 6% increase in standard deviation for the same pursuit of a 1% increase in return or worse.  Conversely, the ability to reduce risk can become lessened at the conservative end of the spectrum.  At some point a decrease in standard deviation is nearly impossible, and a more conservative portfolios only effect is to reduce expected return.

As a general rule, we attempt to maintain most of our portfolios between 30 85% equities, with the most appropriate allocation for most individuals between 60 75%.

Q:  What do expected return and standard deviation mean to me?

A:  The expected return is the annualized rate of return that the portfolio could expect to return in the future.  However, the likelihood of getting exactly that rate of return is remote at best.  That is what the standard deviation attempts to explain.  The standard deviation is designed to tell you how much the returns may vary away from the expected.  A good rule of thumb indicates that approximately 2/3rds of the time, the return should fall within one standard deviation (either higher or lower) of the expected return.  The other approximately 1/3 of the time, the outcome will be expected to fall outside of that range and provide much lower or much higher rates of return. 

What this means for most investors:
1) Negative returns are a normal part of investing and should be expected.
2) If you invest for a long enough period of time, you will likely see swings between gains and losses
3) Investing can be a coin flip. There could be a 50% chance of achieving higher than expected returns and a 50% chance of getting lower than expected returns
4) You can control the amount of risk you take, but that does not guarantee the level of return you will receive.

Q:  How accurate are the expected return and standard deviation estimates?

A:  Because these are merely estimates of standard deviation and expected return, be judicious in how precisely these are used.  Although, we make every effort to determine a reasonable estimate, at the end these estimates are based on a variety of factors that include historical data and current interest rate environments that may not reflect future unknown factors.  It is probably a good way to assess the difference between two portfolios, but a less precise, albeit widely used, way to determine the viability of financial planning options.