Investors that neglect to align their portfolios with their tolerance for risk end up doing irrational things that ultimately sabotage their success.
Indeed, there are many stories of investors who dumped stocks after the 2008 market crash and have been afraid to re-enter the market, costing them dearly, notes Mike McDaniel, chief investment officer at Riskalyze, a provider of quantitative measurement of risk tolerance.
“Everyone knows they should buy low and sell high, but do the exact opposite, primarily because they do not know their own risk tolerance,” McDaniel said.
The bull market in large-cap U.S. equities SPX, +0.36% that has lasted nearly eight years with few severe pullbacks has contributed to a false sense of stability, resulting in heavier allocations to stocks by investors who should not be taking so much risk, according to some financial advisers.
Meanwhile, years of falling bond yields, which have undercut a source of income for retirees, have pushed a lot of older investors into dividend-paying stocks or high-yielding bonds that some analysts see as excessive risky.
The 10-year Treasury yield TMUBMUSD10Y, +0.00% currently at 2.4%, has been trending lower since the 1980s, and has averaged below 3% for more than six years. Persistently low yields on government bonds increased relative attractiveness of securities that pay dividends above benchmark yields. Yields fall as bond prices rise.
Low-volatility stocks that offer steady dividends rose in popularity, sending their valuations above historic averages and contributing to proliferation of so-called smart-beta exchange-traded funds.
Smart-beta ETFs by the end of 2016 had accumulated more than $ 500 billion in assets under management, according to Morningstar data.
Meanwhile low levels of defaults in high-yielding junk bonds also made them popular with investors hungry for income.
“We have a lot of people right now who are invested with a full sense of security,” said Mitchell O. Goldberg, president at ClientFirst Strategy Inc.
“People assume dividend-paying quality stocks are not risky, but they will decline just as much as the market during corrections,” Goldberg said.
Wall Street may be somewhat responsible for marketing such products, but Goldberg doesn’t assign the industry the sole responsibility for painting a picture of false security.
“Today, there are a lot of self-directed investors who are reading content online to justify their decisions,” Goldberg said.
The financial services industry largely differentiates a few broad categories for risk tolerance, such as moderate, growth, aggressive or conservative. But these semantics are based on what investors need, ignoring what investors actually want.
McDaniel says that before investors make decisions about what assets to hold, they should figure out their own risk profiles.
“Our research showed that contrary to the conventional wisdom that young people take more risks, more than half of those who are in their 20s and 30s have very low risk tolerance. Similarly, half of baby boomers have higher risk profiles than you’d expect,” said Riskalyze’s McDaniel.
“It is an adviser’s job to find out how much risk you want and how much risk you need[ in order] to give you the best advice and make you stick with it during tough times,” McDaniel said.
Both McDaniel and Goldberg recommend that people who are saving for retirement without the help of a professional adviser take advantage of many online tools to assess their risk tolerance levels.
“There is no such thing as a perfect portfolio, because if it’s not aligned with the investor’s risk tolerance, they are likely to change it, by selling at the wrong time,” Goldberg said.
Indeed, a risk-averse young saver with a diversified portfolio that doesn’t experience wild market swings is likely to stay invested and benefit in the long term, even though returns may be more modest than that of an aggressive portfolio in the short term.
Goldberg’s advice to self-directed savers is to make sure they know what they own and why they own it.
“People have to compartmentalize their holdings and know the reasons for holding different assets. For example, equities in their portfolio is for the long term and cash is for the short term,” Goldberg said.
“Ultimately, people either have to pay for financial advice or spend time educating themselves. Not being financially literate is costly,” he said.