What 2016 Can Teach Us About Risk Tolerance

by: Evan Powers

Summary

Despite widespread predictions of market doom in the case of a Trump election victory, the markets have been resilient (and in some ways cheered the unexpected result).

Still, the discomfort exhibited by many investors prior to the election might be an indication that some investors are carrying more portfolio risk than they should be.

There are three primary elements of a portfolio risk assessment, including both emotional/psychological factors and more quantitative, planning-based factors.

Understanding the interplay among the three elements is a vital step toward building an appropriate portfolio that suits the investor (and his or her broader financial plan).

Political uncertainty does not end with the now-completed presidential election; 2017 will bring a steady stream of global elections and referendums, and investors need to prepare their portfolios accordingly.

In the weeks leading up to this month's presidential election, I fielded an unusually large number of calls and emails from clients, friends and family members, all of them seeking my advice on the "appropriate" pre-election portfolio moves. Should we be raising cash ahead of the election? Selling everything and buying back in after the dust has settled? Hiding out in more conservative investments for a few months? Or should we just stay the course, keep our fingers crossed and hope for the best?

After fielding enough versions of the same question, I eventually felt inspired to write an article on the topic, examining the historical impact of presidential elections on subsequent market returns. As it turns out, that piece was prescient in at least one regard. While noting that the impact of elections on financial markets has generally been a statistically weak and unreliable one, I did mention one trend that still seems to have some amount of staying power:

One of the most commonly cited effects is the "previous 3 months" phenomenon. Over the last 22 elections, the direction of the stock market in the 3 months leading up to the election has correctly "predicted" the winner 19 times: when the market is positive in the pre-election period, the incumbent party tends to hold onto the White House; when the market is negative, the incumbent party loses. The three exceptions occurred in 1956, 1968, and 1980 - interestingly, all Republican wins.

In the generally tense three months leading up to this year's election, the S&P 500 logged a small loss, from a closing level of 2,181 on August 8th to 2,140 on Election Day. True to form, that 1.9% decline portended bad news for the incumbent Democrats, who now find themselves picking up the pieces of an election cycle gone horribly wrong.

And yet, the unexpected result did not yield the widespread predictions of doom that had pervaded the financial media in the weeks leading up to the election. So, does the market's resilience despite the initial shock indicate an unnecessary level of alarm on the part of investors? Were we all simply wrong to have worried, or does our worry reveal something deeper about us as investors?

From my standpoint, the nervousness in the pre-election period revealed not so much an ignorance of the market's likely reaction (or a misplaced emphasis on the role of politics on subsequent market outcomes), but more a recognition of a broader discomfort on the part of the investors in question with their overall portfolio allocation.

In other words, if you're nervous about the impact of an unknown risk on your portfolio (and concerned enough to seek professional advice), then that nervousness alone may be an indication that you need to dial back the riskiness of your investments, election or no election. If your portfolio properly reflects the amount of risk that you're comfortable taking, then you shouldn't have to worry about economic risks, geopolitical risks, or testy presidential elections that have dominated the news cycle for months on end.

So, how should we as investors (and advisors) think about risk more broadly? And how should we determine whether or not we're taking on the "right" amount of risk? Considering the three major aspects of risk assessment can help all of us build a portfolio that truly reflects our attitudes toward investment risk, so that we'll never have to worry again about whether a news event threatens to derail our best-laid plans.

First, there's "risk tolerance"

The most commonly discussed aspect of a portfolio risk assessment is the psychological form of risk - from an emotional standpoint, how much risk is the investor comfortable taking? Some of us are gamblers by nature, adrenaline junkies who are completely satisfied with a volatile portfolio that swings by several percent a day. Others are on the opposite end of the spectrum, willing to accept a very small gain (or even a guaranteed decline in purchasing power) in order to avoid the possibility of a long-term investment loss.

This psychological "risk tolerance" is something that advisors like me often spend an inordinate amount of time trying to divine, like an investment counselor or therapist trying to probe the darkest recesses of our clients' primate brains. Risk questionnaires are circulated and analyzed, discussions about potential market outcomes take place, and the advisor and client eventually arrive at some sort of an agreement about an "appropriate" portfolio allocation given the outcome of the battery of psychological tests.

Unfortunately, these sorts of risk questionnaires are notoriously unreliable, and only occasionally provide a meaningful assessment of a client's "true" attitudes toward risk. For most clients, we might as well be throwing darts at a dartboard or picking numbers out of a hat.

It's a dynamic that isn't limited to investments and risk assessments. In general, people just happen to be very poor at predicting their own behaviors, particularly when the future events to which they're being asked to respond are unknown. We see this difficulty in predicting behaviors in all sorts of arenas, from shopping habits (get ready for the annual parade of terrible holiday spending forecasts) to career paths to even our own voting behaviors.

For example, we might think that we're quite risk-tolerant, but then find out we're not when our investments first take a turn for the worse. As German military strategist Helmuth von Moltke first said (and it has since become a slightly modified, semi-apocryphal quotation), no battle plan ever survives first contact with the enemy. In this case, risk is the "enemy," and we can't truly know what our risk tolerance is until we've been forced to actually respond to the negative outcome of a known (or unknown) risk. Or, as the boxer Mike Tyson more colorfully put things, "Everybody has a plan until they get punched in the mouth."

Frankly, given the difficulty in measuring it, far too much time is spent assessing risk tolerance, at least in its traditional form. Understanding an investor's likely emotional response to a negative outcome is important, yes, but understanding the actual impact on his or her overall financial plan is drastically more important.

Risk capacity and required return

The two other aspects of risk assessment are closely interrelated, but certainly distinct. Both come from a numbers-based, financial planning approach (rather than an emotional basis), and they try to answer two basic questions: How much risk do we need to take in order to meet our future financial goals (required return), and how much risk can we afford to take before the risk of failure becomes too great for our financial plan to withstand (risk capacity)?

Any investment plan needs to start with a well-defined goal (and no, "making as much money as possible" is not a valid response). To do so often means making some projection about future expenses or cash needs, or at least setting a target dollar amount that we're trying to have saved or invested by a certain date (that "target dollar" approach is particularly common when we're investing for a specific goal with a known time horizon, like saving for a down payment on a house, or college savings for our children).

If we know how much we have invested, and we know how much we need in the future, then it's fairly simple to back into a "required return" on those investments. Not every investor needs to generate a 7% or 8% compound annual return; for many of us, our needs are simple enough (or our cash stack large enough) that there's simply no innate need to be taking on outsized investment risks. Just keeping up with inflation may be enough, or even more than enough.

On the other hand, many prospective retirees who arrive at their early 60s with minimal investment account balances but substantial future expenses may be in a bind, needing to earn a significant investment return in order to have any prayer of retiring at their desired age. In some cases, the investors' "required return" may even be too great to be realistically achievable, in which case it's the advisor's job to step in and look for other ways to help make the goals more realistic (like cutting expenses, or retiring later).

The flip side of this "required return" is the risk capacity - instead of attempting to determine how much of a return (and therefore, how much risk) is needed, risk capacity attempts to determine how much risk can be withstood before plunging an otherwise solid financial plan into the gutter. For many investors, risk tolerance can outstrip risk capacity by a wide margin - a client may come to an advisor claiming to have a never-ending appetite for risk, but his financial plan may be vulnerable enough to make outsized risks unpalatable.

Ultimately, it's risk capacity that is at the core of the traditional "glide path" approach to investing. Younger investors can afford to take greater risks, because their time horizon is longer, and they won't need to rely on their assets to provide income for several decades; older investors, on the other hand, have shorter time horizons and less time to make up for investment losses that they may incur. Your retired parents may still feel as though they're capable of emotionally handling investment risk, but that doesn't necessarily mean it's the best idea for their overall financial plan. Many investors learned that lesson the hard way back in 2008 and 2009, and we advisors certainly hope those are lessons well learned for future generations.

Other considerations

Of course, sometimes, questions about risk capacity and required return don't necessarily yield clean and easy answers. Consider, for example, an older married couple, perhaps 70 years old, with assets that are more than sufficient to cover their future costs, even amid significant stress-testing. Should that older couple necessarily be in a relatively standard conservative portfolio, with only 30% exposure to equities, just because of their age?

Or should they recognize that their portfolio may, in large part, end up representing a future inheritance to be passed to their children, and invest more aggressively in recognition of the fact that their children have a much longer investing time horizon and can afford to take on an increased amount of risk? Perhaps the "optimal" approach lies somewhere in between those two approaches, or somewhere else entirely. Risk can be a fungible dynamic, and no two investors will necessarily approach things entirely the same way, even if their financial plans seem nearly identical on the surface.

For one investor, required return and risk capacity may be easy to measure, but might nevertheless take a significant back seat to the importance of the psychological aspects of risk. Some investors would, quite frankly, prefer to make adjustments to their financial lifestyle, making what some would consider draconian spending cuts just to avoid having to take any more investment risk.

Figuring out just how an investor should prioritize the three elements of risk is an ongoing process, not a one-day, one-form, set-it-and-forget-it decision. Our attitudes toward risk can change over time, as can the particulars of our financial situation. Regardless, if we ever find ourselves asking ourselves whether or not we should be dialing back our investment risk, we probably already know the answer before we've even asked the question. After all, sleeping well at night should be the end goal of any and all investment activities.

The 2016 election may finally be in our rearview mirror, but risk lives on, either via policy uncertainty in a changing White House or from a slew of upcoming elections and referendums in Europe and elsewhere (and don't forget, Brexit hasn't gone anywhere just yet). If you were uncomfortable with your portfolio leading in to this year's election, there's still plenty of time to rectify that discomfort. It's never a bad time to reassess our risk stances; it's knowing where to start that can be the tricky part.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The author is a contract employee and partial owner of myFinancialAnswers.com, and he is compensated to provide industry commentary for the site. The opinions provided here may also be published at myFinancialAnswers.com.