Investors often get hung up on the wrong questions. Should I buy more Apple stock? Should I sell this dog of a mutual fund? How will the Fed impact my bond fund this month? These questions can be important. But they pale in comparison to the most significant question for your portfolio: How much risk should I take?
One stock pick or mutual fund isn’t likely to make or break your retirement, but how much risk you take in your portfolio can easily be a game changer. That’s why it is essential that your financial advisor focus a significant amount of time at the start of every client relationship on the question of risk.
Let’s start with an example
Imagine a couple with spectacularly bad timing. They invested $1,000,000 in a 100% US stock portfolio, the Vanguard 500 Index Fund (Ticker: VFINX), at the start of October of 2007. By February of 2009, their portfolio would have been worth $498,049. If they had the intestinal fortitude (financially and emotionally) to sit tight and not sell any of the fund after this remarkable decline, they would have broken even on their original investment in March of 2012.
Now let’s say a 60/40 portfolio was the “right” risk level for this client, and after suffering the decline in their 100% stock portfolio, they admitted defeat and adjusted their portfolio near the bottom in February ’09. They kept 60% of their original investment, moved 40% to the Vanguard Total Bond Index (Ticker: VBMFX) and waited for the market to recover. Had they kept this 60/40 mix constant each month, they would not have broken even until November of 2013.
Had they dialed down their risk level even further to a 40/60 mix, they would not have broken even until July of 2016, almost 9 years after their original investment.
These are the types of errors that can materially change a client’s retirement and standard of living. Imagine if this couple were withdrawing from their portfolio throughout those years. Between their investment loss and the amount being withdrawn, they may never break even, and may even need to reduce their standard of living to avoid running out of money.
What if they planned ahead?
Now let’s imagine the couple had gotten their risk level right from the start. Not only would they have broken even sooner, but their portfolio today would be in much better shape than the portfolio with poor timing.
Unsurprisingly, the 100% stock investor did better over the course of a bull market. 100% stocks may be an appropriate risk for a different investor. But by taking only as much risk as they could comfortably handle, this hypothetical couple could sleep at night and avoid panic-selling during a decline.
A variety of factors influence how much risk to take in a portfolio. Risk “tolerance” (how much risk you can stomach), time horizon, spending needs, longevity, and income sources all play a role. When assembling a portfolio, it’s crucial to start with the big question of risk, and then focus on implementation. It just might be the most important question to get right to protect your retirement.