Monday , March 30 2020
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A Crisis is the Worst Time to Learn Your Risk Tolerance

Summary:
When I talk to new clients I always tell them “a crisis is the worst time to learn your risk tolerance”. Unfortunately, far too many people do exactly that. They chase returns during a bull market when investing looks easy and then when times get tough they learn that, while they thought they were chasing higher returns, they were only chasing higher risks. Then they rebalance and sell low to align their portfolio closer to their actual profile except usually too far in the other direction. Look, I’m not gonna bull shit anyone. This whole corona virus thing sounds scary. According to some people it’s going to wipe out a big part of the population. According to other people it’s going to burn itself out like a common flu once the weather improves. I don’t know. And neither does anyone

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When I talk to new clients I always tell them “a crisis is the worst time to learn your risk tolerance”. Unfortunately, far too many people do exactly that. They chase returns during a bull market when investing looks easy and then when times get tough they learn that, while they thought they were chasing higher returns, they were only chasing higher risks. Then they rebalance and sell low to align their portfolio closer to their actual profile except usually too far in the other direction.

Look, I’m not gonna bull shit anyone. This whole corona virus thing sounds scary. According to some people it’s going to wipe out a big part of the population. According to other people it’s going to burn itself out like a common flu once the weather improves. I don’t know. And neither does anyone else with any degree of certainty. This is one of those tail risks that you can’t even begin to quantify.

One thing we know for certain, is if days like yesterday scared you or made you call your advisor looking for solace then you’re probably not prepared for something that’s really scary like a 50%+ decline. And that means you’re setting yourself up to learn your risk profile at the worst time. And when you learn that risk profile you’ll rebalance to make yourself feel better and you’ll likely be selling low after buying high.

The thing that makes investing so hard is that we’re competing against an immeasurable counterfactual. Most of us like to benchmark ourselves to the S&P 500 or a 60/40 portfolio, but the reality is that our behavior is the only benchmark that ever matters. If you can’t stick with a 100% stock portfolio through a 50% downturn then the S&P isn’t your benchmark. If you can’t stomach a 35% downturn then the 60/40 isn’t your benchmark. The only benchmark that matters is the portfolio that helps you stick to your financial plan through thick and thin.

So, how can we do that? Here are some questions that might help you figure out whether your profile is right:

  • What’s your max paint point? That is, what is the loss of principal in your portfolio that would make you tap out? 
  • What return do you need versus what return do you want? We all want higher returns, but most of us end up chasing higher returns than we need thereby chasing higher risk and increasing our behavioral risk. 
  • Are you allocating savings or are you gambling? Thinking like a saver helps you get away from the mentality that your portfolio needs to be some sort of market beating alpha generating portfolio. Most of us should spend more time treating our savings like actual savings and less time watching financial TV and treating it like casino money. 

The only other thing I can tell you during this strange time is this – turn off the TV. Stop feeding your brain with behavioral risk. Stop reading pundits who pretend to know exactly what the outcome will be. And position your portfolio so that you know you can stick with it even if a worst case scenario were to transpire.

NB – This transmission was sent from the Roche Bunker in Encinitas CA where actual Corona is plentiful. Godspeed. 

Cullen Roche
Former mail delivery boy turned multi-asset investment manager, author, Ironman & chicken farmer. Probably should have stayed with mail delivery....

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