About a week or so ago, I met with a very nice couple in my Duxbury office, let’s call them Hal and Stacy. They both are in their mid-50s. They live in a beautiful waterfront home in Duxbury and have three daughters in college. Over the years they have done well, financially. Last year they sold their construction company to a larger company for a few bucks. Hal currently has a retail brokerage account and has managed their investments with some help from brokerage firms over the years. Hal’s also what you might call a “news junkie.” He doesn’t get his news from just one network, and if you ask him anything about current events, he’ll tell you in detail everything he knows.
Hal was worried, with everything going on in the world, that their nest egg was in danger. He saw existential threats to their investment portfolio amidst news of trade wars, real wars, tariffs, counter-tariffs, real news, fake news, saber-rattling, and frayed global relationships. I agreed that it is crazy out there and only getting crazier.
Hal was asking for help.
So, I asked Hal what process he followed for investing. Did his process use facts instead of feelings to manage downside risk, thereby minimizing volatility? I asked him how his current strategy behaved during some of the worst of times, such as 2008.
Hal’s response was, “I feel like I have been lucky.”
Hmmm . . . we have a problem.
As I took some time to better understand their portfolio and their strategy, one thing became crystal clear to me immediately: This couple was exposed to a significant amount of risk. Their multi-million dollar portfolio comprised equities, mainly in just a few sectors. There was very little diversification and certainly no embedded downside risk management. While the stocks Hal and Stacy invested in had produced excellent returns over recent years and some dividends, their broker provided no protection to their assets if those sectors took a prolonged tumble.
Hal and Stacy had been behaving like many other investors. They chased gains and did not understand the risk associated with those potential gains. That’s a recipe for financial disaster.
As an investor, keeping up with what’s happening in the world helps to make informed decisions. But at a time when you get whiplash watching things change from one day to the next, it’s important to keep things in perspective. Building a sound investment strategy that is defined by risk, then understanding its behavior during the worst of times, will help to make you less susceptible to acting rashly during periods of market turbulence. It will also help you to stick to a long-term strategy and to maintain discipline amongst chaos.
For anyone but the luckiest investor, it is folly to base investment decisions on feelings, rather than logic and rules. Because when you’re talking about your wealth, luck should have nothing to do with it. The canonical study on how behavior affects investor returns is the annual Qualitative Analysis of Investor Behavior (QAIB) from Dalbar, a well-known financial services market research firm. Dalbar’s research indicates that most individual investors make investment decisions based on what you might call gut instinct: emotions and perception.
Dalbar’s research also concludes that most individual investors fail to produce the returns of institutional investors. Those poor-performing individual investors often don’t have an investment process in place, beyond “buy low, sell high.” And individual investors either cannot or do not stick to that process.
An investment process must include the appropriate assessment and management of risk. This is critical to long-term investment success. And with such unsettling news nearly a daily occurrence, now is the time for investors to assess the risk they have assumed in their portfolios.
I explained to Hal and Stacey the importance of diversifying their portfolio – distributing assets among different asset classes. Their portfolio should be structured not only among different asset classes, but classes that have different levels of market movement, correlation, and risk. Depending on the size of a portfolio, diversification can often include four or five main asset classes, such as: domestic stocks; international stocks; corporate, municipal, and high yield bonds; short-term fixed income instruments and alternatives. Each asset class serves to help insulate a portfolio from specific risks the others may be susceptible to.
Rebalancing their portfolio can help Hal and Stacey reduce their risk. Rebalancing will also help Hal and Stacy remain focused on long-term goals. What’s more, rebalancing gives them the opportunity to better assess their risk tolerance and course-correct as necessary.
After reviewing their portfolio, Hal and Stacy realized they were putting their assets and financial future at unnecessary risk by having too much exposure in just a few sectors. We diversified their holdings into a combination of domestic and international stocks, corporate, municipal, and high-yield bonds, alternatives, and treasuries; a combination of asset classes that better suited them based on our risk assessment.
You see folks, if you manage the potential losses, the gains will take care of themselves.
We ended up with a well-diversified, actively-managed strategy; a strategy using quantitative data to help provide Hal and Stacy the highest level of success defined by their risk, rather than luck. This will help to give them the peace of mind they need to keep from making emotional investment decisions.
I will ask you this week the same hard questions I asked Hal and Stacy. What process do you follow for investing? And does your process use facts instead of feelings to manage downside risk? How would your current strategy have behaved during some of the worst of times, such as 2008? Is your strategy’s cornerstone built on risk first?
Having sound answers to those questions just might help you, like Hal and Stacy, stick to your plan, even as you watch the “fake news” every night.
And always, be vigilant and stay alert because you deserve more.
Have a great week!
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, a wealth management firm with offices is Falmouth, Duxbury, and Mansfield. Jeff can be reached at email@example.com.
Cutter Financial Group LLC (“Cutter Financial”) is a SEC Registered Investment Advisor.
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