Over Time, Stock Markets Tend to Go Up

How long will the current bull market last?

Over longer periods of time, we know that the worlds stock markets have generally gone up. From 1900–2013, stocks outperformed inflation by over 5% per year. From a simple point of view, this means that new stock market highs have been the norm, not the exception. In one way, this reflects the triumph of capitalism and the general improvement in living standards around the world. It is important, however, to remember that it is not that simple.

Regardless of past performance, investors should not take more risk than they are able, willing or need to take. Many an investment plan fails because investors take an inappropriate amount of risk. Then, when the risks show up (perhaps unexpectedly), the plan may be abandoned, either out of necessity or because panic sets in.

Investors should not take more risk than they are able, willing or need to take.

Determining Your Asset Allocation

When establishing an asset allocation, investors should consider:

1. Their investment horizon
2. The stability of their income
3. Their ability to deal with the stomach acid created by bear markets The rate of return they need to achieve their goal

We believe it is critical for our clients to factor in their risk tolerance when determining how much to allocate to stocks. It is an important step in setting reasonable expectations for long-term portfolio performance when planning for retirement and other financial goals. If you ask 100 different advisors about their approach to investing, you could easily get 100 different answers. While there are an unlimited number of methodologies that can be applied to investing, there is one common thread. That is the notion that risk and reward are related. All advisors agree that in order to increase your expected rate of return, you need to increase your exposure to risk. For this reason, we need to know how much risk you can take.

Three Questions You Must Ask

How much risk an investor is willing to tolerate is often difficult for them to even contemplate. Why? With increased exposure to risk comes an increase in a portfolios expected volatility. Specifically, the value of a portfolio with greater risk exposure will tend to change, both up and down, by larger amounts than a portfolio with less risk. As advisors, we help clients ascertain their true risk tolerance. Unfortunately, its not a simple question with a simple answer. The reality is that most people are far more tolerant of upward volatility than downward volatility. Right? As much as that seems like a no-brainer, it isnt because there is no free lunch in stock market investing. We are always in search of new ways to truly understand our clients appetite for risk.

To do this, we ask three key questions with respect to a clients portfolio allocation to equity:

1. Do you have the ability to take this amount of risk?
2. Do you have the willingness to take this level of risk? Do you have the need to take this level of risk?

If you cannot answer yes to all three questions, then you should seriously contemplate reducing your equity allocation.

Whats Your Real Risk Tolerance?

U.S. markets are continuing to hit all-time highs. Because of this, those who have maintained an ability, willingness and need to invest in stocks have likely been rewarded for doing so. Given the performance of equities in our client portfolios over the last five years, we shouldnt be that concerned about risk, should we? Wrong! Doesnt it make sense that, after a period of higher-than-expected returns for stocks, its possible that our need to take the same level of risk is reduced (even if our ability and willingness to take risk hasnt changed)? The questions we ask need to be revisited on a regular basis to ensure clients maintain progress toward their goals while minimizing risk.

Even if you think that your willingness to take risk is unchanged, consider a question I ask clients, and encourage everyone to ask themselves today as they contemplate their portfolio allocation and their own tolerance for risk: Which will make you feel worse (and have the greatest impact on whether you reach your goals)—missing out on the next 20% run-up in stocks or participating in the next 20% downturn? If only we knew what was coming next.

This entry was posted on Thursday, May 15th, 2014 at 5:59 pm and is filed under Advice & Insight. Wealth Strategies .