By Michael Hathaway, CFP®, CFA®, AIF®
During the last 25 years, while taking finance classes in graduate school and then studying for professional certifications in finance, I have probably experienced most of the traditional academic discussions about risk and return. Two specific discussions include:
- Risk and return are intrinsically related: risk (or investment price volatility) is the “price we pay” to get investment returns. The more risk we are able and willing to take/accept in our portfolio, the greater the possible returns we can/should receive.
- There are two categories of investment risk: one for which investors are compensated (with higher expected returns) and the other kind for which investors are not compensated:
- Systematic risk (or market risk) is risk that is inherent in being invested in risky assets, and which cannot be diversified away. Investors who accept this type of risk expect to be compensated for doing so in the form of higher expected returns. The most common example of this is “equity market” risk, which is the risk that exists in equity securities, which manifests as greater price volatility (compared to safer, less risky assets).
- Non-systematic risk (or idiosyncratic risk) is any other risk that is unique to a particular investment. This could be a country-specific risk, an industry-specific risk, or a company-specific risk. The expectation is that these risks can and should be “diversified away,” which is accomplished by holding additional investments that spread these unique risks across various (all?) geographies, multiple industries, and many companies. Because these risks can be diversified away, the investor should not expect to be compensated for taking any non-systematic risks (e.g., when an individual company misses earnings forecasts, a company goes bankrupt, or a country experiences instability, etc.).
These concepts of risk and return are robust and academically sound. I don’t think there is anything wrong with these explanations of risk and return (especially since they were written and taught by people much smarter than me). Over time, however, I have developed a working definition (concept) of the relationship between risk and return that I prefer. It is that:
- Markets (and prices) for risky investments go up and they go down.
- I don’t know anybody who thinks about prices going up as “risk”; therefore, I consider increasing markets/prices as simply “return.”
- Similarly, most (non-financial) people don’t think about prices going down as “return”; therefore, when markets go down (or securities experience lower prices), this is simply “risk.”
Most often market risk, or the risk of declining prices, only happens historically for “short” periods of time. Many people in the financial industry think of price volatility on a short-term basis, like days, months, or maybe years (annual price volatility). However, an investor can think in terms of longer time horizons, like decades (the length of a working person’s career, or the time spent in retirement). Then, it turns out that a well-diversified investment portfolio doesn’t actually experience nearly as much volatility of prices (they are smoothed out), and in fact, over longer-term time periods (like 20 or more years), there are few (if any) of these longer periods where prices have decreased at all.
My takeaway from this history and perspective is that if we invest for the long term (I think at least 10+ years), we can have confidence that we will be rewarded for bearing risk in a well-diversified investment portfolio. If we do not have that long of an investment time horizon (say, for shorter-term goals like a wedding or college), then we should be aware that there is a sizable risk that our investment will be worth less when we need it if we have invested in risky assets (like stocks), and instead, we should be investing in safer assets (like bonds).
My Personal Approach to Building Investment Portfolios
Based on this relationship of risk and return described above, how do I approach building an investment portfolio, either for myself or for my clients? I believe there are four key principles that are critical to creating an ideal investment portfolio for any individual.
1. The most important decision for any investor to make is the overall portfolio asset allocation, essentially deciding “How much risk (of downward price movement) am I willing to accept in the portfolio?”
- This desired level of risk can be driven by many factors, such as the investor’s time horizon (time until cash flows are needed from the portfolio), an investor’s overall wealth and income profile (and what percentage of the whole the portfolio comprises), and the investor’s emotional ability to handle the volatility of the price/value of the portfolio in the intermediate time frame.
- This is the most critical factor because if the investor has too little risk in the portfolio, it may not grow enough to meet the investor’s goals. If the investor has too much risk in the portfolio and decides to “abandon the plan” in a time of market declines, the investor will be locking in permanent losses and may have negatively affected the ability to meet their investing goals.
- Related to the overall portfolio asset allocation, it is important to periodically “rebalance” the investment portfolio, bringing it back in line with the original risk allocation. Failure to rebalance periodically can result in a portfolio getting out of alignment and developing much more risk than the original portfolio contained (and that the investor desires), and a subsequent down market can trigger the “panic” we had hoped to avoid.
2. The second most important action to take in building an ideal investment portfolio is to diversify broadly. Very broadly. As in, for equity securities, own a “piece” of every company in the world that is available to be purchased. There are two key reasons why. First, aggregated worldwide equity prices tend to move in conjunction with worldwide economic growth; as the worldwide economy grows, so grow stocks in the aggregate. Second, every period (year, etc.) a few companies’ stocks tend to outperform the markets to the upside (and a few to the downside), and the research shows that it is not possible to consistently and reliably determine in advance which companies/stocks will be outperformers or which will be the laggards. Therefore, my guideline is to own some of every publicly available company stock.
3. The third most important action is to keep fees low. There is no correlation between what you pay for an investment (in terms of fees and transaction costs) and what you receive in return before fees are considered. We know that while investment returns will vary, fees and costs accumulate every year. Therefore, for long-term investment success, keep fees and costs low.
4. Fourth, it is important for investors to manage their emotional selves. Research describes a “behavior gap,” which is the difference between how “markets” performed over a given period of time, and how individual investors’ portfolios performed during this period. This behaviorally driven effect (gap) is primarily related to moving in and out of investments and may include buying and/or selling securities at inopportune times. Managing their emotional selves helps investors have longer time horizons, remain invested through turbulent markets, and keep focused on the attainment of their personal investment goals.
5. Finally, be tax aware. I do not have enough space in this article to unpack everything about being “tax smart” throughout the investing process (watch for additional articles going into more detail). The impact taxes can have on an investor’s portfolio (and therefore the after-tax returns) are dramatically affected by choices an investor makes with respect to asset location (using accounts with different tax statuses – taxable, tax-deferred, or tax-free) and how different types of assets are placed in these different kinds of accounts to improve tax efficiency over the investor’s lifetime.
How Can We Help You?
While there is no single ideal portfolio for everyone, I have followed the above principles in my personal portfolio. When we build portfolios for our wealth management clients, we do the same. We invest in low-cost, low-turnover, widely diversified mutual funds and exchange-traded funds (ETFs) that invest in a mix of equity and fixed-income assets that, in aggregate, are in line with the individual’s risk tolerance and time horizon.
If you would like to learn more about investing or would like some help building this kind of portfolio for yourself, please email me at Mike@wealthmatters.com or call (707) 428-5500 to get started. We are in the business of recommending financial strategies and structuring investment portfolios that are consistent with the unique values, goals and priorities of each client.
Michael Hathaway is a fiduciary financial advisor at Epsilon Financial Group, Inc., an independent, fee-only wealth management firm. Mike has worked in the finance industry for more than 20 years and brings a wealth of knowledge and experience in sophisticated financial planning to help his clients make sound financial decisions. He is known for caring deeply for his clients’ well-being, being compassionate, and thinking creatively to help clients attain their financial goals. He prioritizes building long-term relationships and takes the time to listen, understand, and explain so that his clients feel confident in their financial plan. Mike is a CERTIFIED FINANCIAL PLANNERTM, Chartered Financial Analyst® (CFA®), and Accredited Investment Fiduciary® (AIF®) professional; he has a bachelor’s degree in cybernetics from UCLA and an MBA in finance and accounting from the University of Virginia. When he’s not working at Epsilon, you can find Mike enjoying anything related to exercise and fitness. He especially loves activities in the great outdoors, such as mountain biking, camping, hiking, and snowshoeing. In the fall of 2016, Mike successfully climbed to the top of Mount Whitney in a single day, the highest peak in the continental United States. To learn more about Mike, connect with him on LinkedIn.