What’s Your Risk Tolerance? Take the Brexit Test
By 2009 investors were fully aware of financial risk; whether they remain awake to its nature for another generation, as they did after the market collapse of 1929-1932, or for less than a year, as they did after 2002, remains to be seen.
Financial adviser and author William Bernstein wrote that in his 2010 book, The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between. Six years later, Brexit has burst on the scene to provide a fresh read on investors' awareness of, and reactions to, risk.
Reports from fund families such as Fidelity Investments and T. Rowe Price, robo-advisers such as Wealthfront Inc., and advisers at much smaller firms don't suggest panic. Fidelity said that last Friday customers made 2.25 buys for every sell; the ratio fell to 1.67 on Monday, then rose to 1.88 on Tuesday. At Wealthfront, far fewer clients even logged into their accounts than did during last August's market turmoil, when about a third logged in, the company said.
But resilience gets tested in the face of unsettling news, and we're likely in for a long and chaotic stretch. Now's the time to assess how you felt and what you did, if anything, the day Great Britain voted to exit the European Union, and what you might be tempted to do in the coming weeks and months. Two years out—10 years out—will you look back on your reaction with satisfaction or regret?
Here are a few ways to test your risk tolerance—and improve your response to risk—and a bonus financial mantra to quote when the markets gyrate.
Create a worst-case scenario
What's the nightmare for your portfolio? Losing 50 percent? Losing $50,000 or more in a day? How much would that change the likelihood that you'll meet the most important goals in your life, whether it's funding your child's education or retiring?
Mark your limits. A portfolio should be a blend of risks and rewards that you can live with across market cycles, so that you don't damage your long-term wealth prospects with knee-jerk reactions to volatility. Staying in the market through times of stress can have big payoffs.
Fidelity compared the returns of 401(k) savers who bailed out of equities at or near the market bottom in late 2008 or early 2009, and had stayed out as of yearend 2015, with the returns of people who maintained a stake in equities through the whole period. The payoff from sitting pat? About $82,000, as shown below.
One way to lessen stress in market turmoil is to divvy up assets into short-, medium-, and long-term buckets that correspond to various goals.
The short-term bucket might hold enough money to live on for five years 1 It's an ambitious goal, no doubt, since many Americans don't have any emergency savings. But the logic of it is sound. , in investments with no risk and so not much return, said Kevin Meehan, a certified financial planner at Wealth Enhancement Group in Itasca, Ill. The medium one can be balanced between stocks and bonds, maybe 60/40. The long-term bucket can be more heavily weighted in equities.
"Because you have five years of whatever you need to spend put aside, you're more likely to be able to tolerate the ups and downs," said Meehan. "By segregating the money, you give people a lot of peace of mind."
There's another type of bucket some wealthy investors create. It's "play"money that they can speculate with. One client of Meehan's has a separate account that makes up just 2 to 3 percent of her money. She decided to get more aggressive with that account on Monday, in the wake of Brexit, and moved to being fully invested, rather than half invested, in equities.
Chant it: Volatility is normal. Volatility is normal...
It's the really long, calm stretches in the stock market that are unusual. Kevin Couper, a planner at Sontag Advisory in Manhattan, takes his clients through historical markets, both short- and long-term, to educate them about volatility and how normal it is.
"We encourage clients to expect volatility and to get comfortable with the idea that there will be down years and other market crashes to come, but that if they are positioned correctly they will be able to ride the waves and not sell at the wrong time," he said.
Keep in mind that your risk tolerance changes with the market. "The reality is that people have a higher risk tolerance in good times and a lower one in tougher markets," said Meehan. Advisers should do an overall analysis of a client's long-term goals to figure out the rate of return a client needs.
"Bottom line," he said, "why take more risk than you need to meet your goals?"
Understand the risk/reward trade-offs
Risk tolerance questionnaires are a nice place for investors to start, said certified financial planner Randy Bruns of Highpoint Planning Partners in Downers Grove, Ill. But they rarely quantify the significant change in required annual savings for investors as they move up or down the risk/reward spectrum.
Bruns uses the example of a 40-year-old woman who has $100,000 and hopes to accumulate today's equivalent of $1 million by age 65. Based on historical returns 2 The returns reflect calculations made by Vanguard Group based on the historical performance of broad market indexes including the Standard & Poor's 500 Index, the Dow Jones Wilshire 5000 Index and the S&P High Grade Corporate Index. , he said, she would need to save $7,000 a year if her portfolio is 100 percent in stocks. If it's split between stocks and bonds, she'd need to save about $12,700 a year. If her portfolio is 100 percent in bonds, she'd need to save more than $24,000 a year. And if she had that $100,000 in a money market fund, she would need to save more than $33,000 a year.
That's the price of being too conservative, said Bruns. More of the nest egg must be built by personal contributions if less of it is fueled by compound growth of investments in the portfolio.
Remember: Market timers usually lose
Morningstar does a study every year to track how the average mutual fund investor's returns differ from the average mutual fund's returns. Investors tend to buy high and sell low and hold mutual funds for years, not decades, so the results can be quite different.
In its 2015 report, Morningstar looked at the average of the gaps for five-year periods. It found that average returns for the time investors owned a fund trailed the actual performance of the fund by about 1.32 percent 3 The gap between investor and fund returns narrowed in 2014, however. Why? In a rising market, "investors were less likely to sell a fund because of poor performance, and, if they did, they likely jumped into a new fund that generally performed well," said the study. "The long run of the equity bull market is much easier on investor returns than wrenching pivot years when big gains turn to big losses or vice versa, prompting many investors to sell low or buy high." , on average, over the long term.
It may not seem like a lot. But with many experts saying that market returns are likely to be muted for years to come, every bit of return counts.
"Overall," said Meehan, "the best strategy is one you can stick with."