How to Avoid a Portfolio Attack
Move over, diabetes. Heart disease, step aside! Investors have another health condition to be concerned about. I’m talking about a portfolio attack caused by unnecessary or excessive financial risk.
While we understand the risks of drinking and driving, smoking, or not eating properly, we may not recognize a risky portfolio when we see it, or understand the negative consequences – to our physical and financial health, as the result of stress brought on by losing our savings.
Some in the financial industry, however, have been minimizing this danger. They are trying to convince Canadians that today we are immune to a serious stock market crash. But history doesn’t back them up.
In 1973, a portfolio that was 50% US stocks and 50% government bonds would have lost more than 20% by the time the market stopped falling in 1974. Could this happen again? Not likely, if you believe those who sell stocks. However, other experts say that it is possible, even probable, under normal market conditions. And almost all agree it is highly likely, should North America experience another serious terrorist attack or a breakout of the much-feared avian flu, for example.
The brutal truth is that losing 20% or more of our capital can ruin our retirement. For those with more than enough capital to live on, that may just mean feeling foolish and having less money to leave to the kids. For others, though, it may mean having to change their lifestyle – perhaps selling their home or giving up their Florida vacations.
The good news is that most of us can realize our retirement goals without taking unnecessary risk. And if you have a risk problem, it can be easily and painlessly solved as long as you address it before it’s too late.
There are three types of risk:
- The normal fluctuation of the stock market, called systematic risk, which can’t be avoided if you want the higher returns associated with stocks.
- Individual stock risk, which is the risk that your stock will fall in value even though the rest of the market goes higher. (Nortel is a particularly gruesome example.) This risk can be avoided completely by buying a mutual fund or an exchange traded fund.
- Unexpected risk, where the stock market drops by an amount far outside the normal range of fluctuation. This could happen if the Chinese Government stopped buying US T-Bills, for example, or if the housing market collapsed.
It’s an unavoidable fact that aiming for a higher return requires higher risk. But the risk tolerance questionnaires used by the industry tend to put the average investor into a portfolio with too much risk. This is great news for brokers, who earn higher fees on the riskier portfolios. But what’s good for the retiree?
Here’s the bottom-line principle to follow: Find out how much risk is necessary to earn the required rate of return, then construct your portfolio to take that amount of risk and no more.
Can you avoid all risk by putting all your money in T-Bills or GICs? Definitely not! For maximum safety you must also address the risks of inflation, deflation, income tax, currency, and liquidity, just to name the more obvious threats to your capital. Proper diversification is the answer. Most portfolios I’ve seen can be easily redesigned to earn the same returns with lower risk simply by upping the percentage of international investments and avoiding sector concentration.
To begin to address this question of risk, you must ask your advisor these three questions:
- What average rate of return do I need to earn to achieve my goals?
- What average rate of return is this portfolio expected to make over the long term?
- How much could this portfolio drop in the event of a large-scale disaster?
If your portfolio is designed to make more than you need to make – and you are not comfortable with the potential loss you would face in a 1929-style disaster – ask for a lower-risk portfolio.
One of the hardest lessons to learn is not to be greedy. You are embarrassed and maybe even irritated when your neighbour brags about his double-digit returns and you’ve earned a measly 6%. However, remember that his returns are higher not because he’s smarter, but because he’s taking more risk, plain and simple. He may be way ahead of you this year but experience his own personal financial meltdown next year--while you are smugly relishing your boring returns!
What we’re talking about here is your future financial – and physical – security. Why risk a portfolio attack when it is so easily prevented?
