“Where do you see yourself in five years?” “What are your long-term goals?" “Our business strategy is…” These statements are familiar to most anyone. When I was younger, I don't recall ever being asked in an interview where I saw myself in six months. Nor can I imagine sane individuals forming a new company based solely on a six- to 12-month outlook. The challenge is and has always been to remain focused on longer-term goals in the face of shorter-term events. This is particularly true in investing, and this article will examine why a long-term view is crucial when determining your personal risk tolerance as well as assessing market conditions and investment options. (For related reading, see: A Look at the Shifts in Globalization in Markets.)
How to Determine Your Core Risk Profile
An investor's core risk profile describes the range of his or her true comfort zone with risk. While it tends to be more or less consistent throughout a person’s life, it can shift over time, depending on one's level of education, years of experience, quality of advice, or underlying wealth and time horizons. It is important to understand that the ability and the desire to take investment risks are different concepts, principal risk and volatility risk are distinctly different risks, and the amount and type of risk you can and should accept depends on more than just age and wealth.
So ask yourself, what do you need your investment portfolio to do for you in five, 10 or 30 years? What will you do if stock markets take a nose dive or interest rates skyrocket? How much money do you plan to deposit or withdraw from the portfolio? What is the timing of those cash flows? What would change in your life if you lost 10% or 20% of your wealth tomorrow? Thinking through these questions is a good place to start when determining your core risk profile and developing a long-term investment strategy. (For related reading, see: Long-Term Investing: Just How Long Do You Mean?)
How Current Conditions Can Affect Investing Strategy
Understanding your core risk profile is critical because short-term events, whether positive or negative, grab headlines and create short-term obstacles that must be overcome. When filling out a typical risk profile at the onset of a relationship with an investment firm, short-term issues like economic or market conditions can have an effect. If current conditions are positive, you may feel more optimistic, which might lead you to feel comfortable in the upper part of your core risk profile range.
Conversely, worse conditions may put you at the lower end of the range. It is important to understand that these situational risk profiles have risk tolerance ranges of their own, and the upper or lower level of that range may fall outside of your core risk profile. If so, it is typically discovered when uncertainty hits the economy or markets, causing the individual to overreach for either return or safety. When fear and greed magnify the impact, an overreaching investor soon realizes he or she is outside her comfort zone and may rush to make a reactive portfolio adjustment, taking him or her from one extreme of the core risk profile to the other.
One of the biggest built-in advantages an individual has over institutional investors is the ability to maintain a long-term investment strategy in the face of near-term under-performance. Avoiding knee-jerk reactions and the constant shifting of strategies to keep up with the news de jour is a good place to start for most investors. (For related reading, see: 4 Benefits of Holding Stocks for the Long Term.)
The Role of an Investment Manager
Part of an investment manager’s job is to help clients establish and maintain longer-term investment strategies, despite what is transpiring in the shorter-term. Some business and economic cycles make that job more difficult; others make it easier. There are times to lighten a position in an asset class, industry or security, but moderation is a key component. Since market reaction to certain events can be swift, vicious and often overdone, reactive portfolio adjustments are typically too late and can do more harm than good in the longer term.
Whether one has a personal portfolio or is participating in a 401(k) plan, the initial and ongoing allocation management makes a meaningful difference for most investors. A rational allocation that is in line with the long-term objective and is consistent with the investor’s core risk profile gives the investor the best odds of negotiating the never-ending supply of short-term obstacles. A conservative investor could use a combination of cash, bonds, and stocks to create a comfortable allocation. They could then make sub-allocation adjustments to the maturities and credit quality for bonds, sectors or industries for stocks, as well as international and domestic adjustments. A growth-oriented investor who is comfortable with a portfolio of 100% stock could use their allocation to mitigate the economic risks between U.S. and international stock markets, economic sectors and industries.
All types of investors should use expected cash flows to adjust their portfolio’s overall allocation and weighting in specific securities as desired, to control the risk level of the portfolio. In any case, maintaining a portfolio that is only on the periphery of one’s core risk tolerance opens the door for a short-term event to cause a reactive portfolio adjustment, making it nearly impossible to achieve long-term investment objectives. (For related reading, see: 6 Asset Allocation Strategies That Work.)