Investors have become financially complacent in recent years as the market has lulled them with ever increasing gains and returns.
When alarm clocks went off in February 2018 with one of the biggest daily and weekly losses in market history, the realization of what it means to be in the market became all too real. Unless you have been totally cut off from the news, you could not miss the turbulence the financial markets have experienced.
The Dow Jones Industrial Average set a record when it dropped over 1,000 points in one day. If you were invested in the market, what did you do? Did you buy, sell or hold your position? According to an editorial by Investment News, “Luckily, the preliminary evidence suggests that most investors stayed calm and did not rush to sell.” Were you like most investors?
You need a plan
In the words of Alan Lakein, a management expert, “Failing to plan is planning to fail.” Before investing in the market, you should be prepared to potentially lose some or all of your investment. Therefore, only use money not needed for any other purpose. This may sound a bit harsh, but it’s true.
Obviously, investing into any financial market involves some degree of risk. The question is how much risk you are willing to take. If you think that keeping your money in cash is a safe play, you might be surprised to learn that inflation will erode its value over time, as current interest rates are near zero. Keeping cash “under your mattress” and away from banks or other financial institutions is vulnerable to the same purchase and inflation risks, and can be a total loss if stolen.
Time can be your friend or nemesis depending on when you begin your financial journey, and you’ll hear this advice repeatedly. A younger investor has time to recoup market losses versus someone older who may not be able to sustain a loss because of their shorter timeframe. The amount of risk an investor should take is a personal decision based on their risk tolerance and the expectation for some level of financial return at a future date.1
Your gross portfolio includes not only your financial components but according to Joshua Kennon, a personal finance expert, it also “Encompasses so much more— your emergency cash reserves, your insurance coverage, your funded retirement accounts, your real estate holdings, and even your professional skills that determine the income you can potentially earn should you lose your job and have to start over.”2
Risk adverse or risk taker
Before investing in any financial asset, the amount of inherent exposed risk should be calculated and evaluated. Standard deviation is one risk-assessment tool used to determine possible gains or losses on either side of a bell curve. If a concentrated position is taken in an investment, e.g., 100 percent, then that investment is exposed to the full brunt of the standard deviation with positive or negative returns.3 Are you willing to be exposed to the risk of impressive gains but equal or greater losses?
Building a smart portfolio
Diversification is how advisors and investors mitigate the possibility of wild market swings. It is sensible to build a basket of financial products that when combined can lower the standard deviation risk with an expectation that different assets will move up or down independent of on another (+1, 0, -1).4
Correlation is the ability to ascertain how different financial products interact. Different financial products can move up, down or not at all in a financial market.5Asset classes consist of like financial products and collectively are part of an index where the correlation is expected to be positive (+1) in similar market movement.6 There are many different indices across the U.S. and world markets.7
A large capital stock, like a “blue chip,” will potentially move in a different direction of another asset, such as gold. Financial markets constantly monitor such things as domestic and international markets and economies, world events, and breaking news.
For example, if the U.S. economy is doing well, with low inflation and unemployment and good corporate earnings, a blue chip stock would be expected to do well. Gold is expected to do better in almost the exact opposite scenario, that is, a recession or period of financial unrest.
In other words, a blue chip stock and gold may be considered to be oppositely correlated at -1. As expected, their relative prices move opposite to each other when having a -1 correlation. This is the concept behind having a diversified portfolio. When some assets go up, other assets may go down, tempering a portfolio’s ever-changing internal asset gyration and net return. Depending on your personal preference and risk tolerance, a portfolio can be developed to include specific and broad-based securities and financial products.
Allocating your assets
After determining your tolerance for risk, begin constructing your financial portfolio after scrutinizing different assets, analyzing financial product correlations, and determining the percentages of asset allocations to yield a 100 percent blend of investments.8 A portfolio can contain almost any security traded on an exchange, such as stocks and bonds, exchange-traded funds (ETFs), financial products sold by a registered agent, commodities, and alternate investments.9,10 Art and rare coins, private equity or debt, hedge funds or venture capital are considered alternate investments.11
The Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) were formed to protect the public from unscrupulous companies and individuals.12 However, despite the existence of these agencies, stories abound of people being financially hurt by fraudsters like Bernie Madoff. Additionally, not every asset class falls under the auspices or protection of these agencies and investors should take note.
Whether a portfolio is concentrated or diversified, the chosen financial products must be acceptable to you. The inherent risk associated with owning the portfolio needs to meet the desired risk tolerance, the anticipated timeframe chosen, and the expected return for participating in the market. Your decisions should take account of short-, mid- and longterm personal needs and goals.
As shown over many years, the markets can be unpredictable, at times displaying low volatility and calm, and then shifting to tremendous turbulence and wild swings of asset values. A well-diversified portfolio of securities can help mitigate some of these concerns by decreasing risk exposure and conserving expected returns.
You can always obtain professional advice for navigating the myriad complex and confusing financial
products available before making your selections. Prior to entering a business relationship with someone, do your due diligence and ensure there are no complaints or sanctions on their record. Visit the “Ask and Check” section of finra.org, where you can view the history of a broker, investment advisor or insurance agent.
Review your quarterly statements for errors and use them as snapshots of your portfolio holdings. Once your plan is established, follow it and be prepared to rebalance as necessary. Avoid trying to time the market, as chasing returns in an up or down market is rarely a good idea.
A certified financial planner (CFP) professional is a fiduciary and required to have a client’s best interest in mind while working together. CFP credentials can be reviewed at cfp.net.
Whomever you consult with, whatever your decision, develop a plan, review it, change it as necessary and stay focused. It’s ultimately up to you to have the total portfolio you want and access when you need it.
H. William Wolfson, DC, MS, CFP, is an independent financial consultant and advisor. He retired after 27 years of practice and remains active volunteering his time to the continued education and success of colleagues. He can be contacted at 631-486-2792 or firstname.lastname@example.org.
Note: The information contained in this article is for educational and informational purposes only. Consider obtaining professional advice before agreeing to any financial purchase, trade, sale or activity.
1 “The Reality of Investment Risk.” FINRA. http://www.finra.org/investors/reality-investment-risk. Updated Feb. 2018. Accessed Feb. 2018.
2 Kennon J. “The Most Important Rule of Investing.” The Balance. https://www.thebalance.com/the-most-important-rule-of-investing-357325. Published Jan. 2018. Accessed Feb. 2018.