Your Investment Portfolio Is Probably Riskier Than You Think

Key Concepts

• Risk Tolerance vs. Risk Capacity: The distinction between an investor's perceived comfort with risk and their actual ability to withstand financial losses.
• Time Horizon: The length of time an investor has until they need to access their invested funds, a crucial factor in determining appropriate risk levels.
• Complacency: A state of overconfidence or lack of concern regarding investment risk, often experienced by older investors after a period of market gains.
• Recency Bias: The tendency to overweight recent market performance and assume it will continue indefinitely.
• Herding Behavior (Crowding In): The inclination to invest in assets or sectors that have recently performed well, often leading to overconcentration.
• Investment Policy Statement (IPS): A formal document outlining an investor's financial goals, risk tolerance, and investment strategy, serving as a guide for portfolio decisions.
• Rebalancing: The process of adjusting a portfolio's asset allocation back to its target weights, typically done periodically.
• "Set it and Forget It" Mentality: An approach to investing that involves making initial investment decisions and then largely leaving the portfolio untouched.
• "Bar of Soap" Metaphor: An analogy suggesting that the more an investor interacts with their portfolio, the smaller it becomes due to transaction costs and emotional decision-making.

Risk Assessment and Time Horizon

Christine Benz, Director of Personal Finance and Retirement Planning at Morning Star, emphasizes that time horizon is the primary determinant of how much risk an investor should take. She suggests age 50 as a rough cutoff point for considering risk levels. Benz observes a prevalent complacency among older adults who have benefited from a prolonged bull market. Paradoxically, as individuals age and gain more experience with market volatility, they may feel more risk-tolerant, yet their capacity to absorb risk actually diminishes. The last significant economic downturn occurred 17 years prior, and Benz posits that experiencing a sustained drawdown today would likely feel different to investors who are now 17 years older. She advocates for preemptive mental preparation and strategic repositioning of portfolios to include a "runway" of safer assets.

Behavioral Mistakes in Investing

Benz identifies two common behavioral mistakes investors make, particularly during bull markets:

1. Recency Bias: Investors tend to believe that recent market performance will persist, leading them to chase past winners.
2. Crowding In: Investors often flock to the "hot" parts of the market, such as AI-related companies and large tech names at the top of indices. While these may be strong companies, Benz cautions against overconcentration, as even high-quality companies are subject to periodic downturns. She notes that while current AI companies are generally considered a higher quality group than speculative ventures like those seen in the late 1990s (e.g., Pets.com), the principle of diversification remains crucial.

Managing Emotions and Portfolio Management

For investors who struggle with emotional control during market fluctuations, Benz strongly advocates for a "set it and forget it" mentality, albeit with a nuanced approach. She uses the metaphor of a "bar of soap": the more you touch it, the smaller it gets. This highlights the detrimental effects of excessive trading and emotional decision-making.

Benz believes that a good once-annual review of a portfolio is sufficient for most investors. While acknowledging the difficulty of tuning out market news and economic conditions, she advises against frequent portfolio adjustments. Instead, she recommends using an Investment Policy Statement (IPS) to guide any necessary changes. The annual review should focus on:

• Performance assessment: Evaluating how the portfolio has performed against its objectives.
• Rebalancing: Determining if asset allocations have drifted and need to be brought back to target weights.
• Tax planning: Identifying opportunities for tax-efficient strategies, such as donating appreciated securities for charitable giving.

Benz concludes that this disciplined, infrequent approach to portfolio management is likely to benefit the long-term health and growth of an investor's portfolio and plan.