Understand Risk

Every “Investment Advisor” will recommend that you diversify your portfolio to “reduce risk”.

This quote from “Future Advisor“, an on-line Investment Advisory firm says it all:

Ultimately, you want to end up with a stocks-bonds mix that’s consistent with your true tolerance for risk, and that you can comfortably stick with even when the market heads south.“.

:”.. reduce risk”, “tolerance for risk”! What risk? The risk that you would panic and sell everything “when the “market heads south”?. That’s the risk the traditional Investment Advisor is referring to.

The traditional perception of risk is taking a short term perspective. Unless the market NEVER comes back, the person who is Investing For Retirement should/must continue to invest during radical market decline in order to take advantage of dollar-cost-averaging, the ONLY proven, assured way to Buy Low, Sell High.

To pull out of the market because a recession is imminent means you are going to try to time the market; e.g. when to sell all, when to buy back in, danger of whipsaw, etc. This market timing strategy has been thoroughly debunked.

Rationale for Diversification Fails In Practice

It is obvious from the diagram below, that investors, en mass bailed out of their equity holdings during the 2008-2009 market decline (>50%). People who were not 100% equity did not see their portfolios decline by the full 50% but they still bailed out of what equity they did have. And, they then missed the subsequent 8 year bull market.

 

Identifying The Real Risk

But this is not the real risk facing the “Investing For Retirement” investor.  The real risk is…

The risk of running out of money during retirement.

Here is a clip from a Gallop poll that supports our position about the real risk facing the IRA Investor:

Personal financial concerns vary significantly across age groups. The top problem for the broadly defined group of middle-aged Americans — those aged 30 to 64 — is not having enough money for retirement, in line with  previous findings, for this group, about seven in 10 worry about not having enough money for retirement
Gallop Poll, April 22, 2014

Confirmed with this 12/4/2016 article from MarketWatch “The Number One Regret Of Older Americans“.

And finally another Gallop Poll from 2016

Pct Americans with this fear

Nowhere in the chart does it say…

“I’m afraid of my portfolio temporarily losing value”

Addressing The Real Risk

The “Investing For Retirement” strategies address the real risk of “not having enough money for retirement”.  The strategies of Investing For Retirement…

. long term horizon,
. faith in the history of the market,
. dollar cost averaging,
. buy and hold,
. single security portfolio,
. ease of investing

combine to ensure that there will be sufficient money to last throughout your retirement.

Other Risks, Not Addressed By Diversification

Failure to Participate Until Retirement

This is the real risk. That you will quit contributing to your Sharebuilder account every month.  You might get discouraged during times of a declining market. It’s tough to see the value of your most important asset, losing value. But this is when you should be rejoicing. Every one of your dollars that you invest during this declining market will buy more shares than they would have when the market was up. These additional shares will ALL increase in value when the market turns around as it invariably does (see History Is On Your Side, Dollar Cost Averaging).

You have to have confidence that the market will recover, as it always has. If you don’t have that core, fundamental belief, then you shouldn’t be invested in the markets at all. Keep investing, no matter what; it’s that simple.

Risk of  Losing Purchasing Power

Purchasing power is the real coin of the realm. You can lose purchasing power because you have less money or you can lose purchasing power because your money won’t buy much. Inflation is a constant, persistent and insidious truth. If  you limit the performance potential of your portfolio by loading up your portfolio with “safe” (e.g. CDs or bonds or money market funds) but poor performing assets, because of fear of losing money, you will lose  purchasing power.

Risk of Losing Potential of Alternative Investments

There may be some other investment alternatives that MIGHT get you more money. You might also lose a lot of money chasing them down. I did. Purchase only VTI and forget about finding a silver bullet.

Risk of Losing the Plot

This is about the risk of not investing continuously until retirement. Following the plan is a commitment to a long term investment policy. There will be all kinds of reasons for not making the monthly investment. The desire to skip “just this month’s investment” will be hard to ignore. The Plan is a “set and forget” plan. Easy to follow, simple to execute, no more having to use energy worrying about what to do.

Risk of Losing Faith

If the market is down for 2,3 years in a row, it is easy to become discouraged as you see the value of your holdings decrease. You give up. As has been demonstrated earlier,  (see dollar cost averaging) these down markets are pure gold for someone who is in the “accumulation” period of the plan. You get more shares for the same amount of money. Later when the market recovers, ALLl those “cheap” shares increase in value and the total value of your portfolio increases exponentially.

Risk of Panicking

This is the “traditional risk” that Investment Advisors” caution against and it is the reason they recommend a diversified portfolio.

If the market is down, worse than losing faith and giving up, you may be tempted to sell all now and then get back in when the market starts back up. This “market timing” is  the worst strategy possible. You are guaranteed to “Buy High, and Sell Low”. You will lose lots of money with this strategy. It has been proven over and over.

Knowing when to get back into the market is the problem. Now? No Wait; Now? No; Now? OK- how much? All of it? Wait, the market just went down again. This behavior will whipsaw you in and out of the market until you have nothing left. Been there, done that. I have a horrible war story to relate about this strategy.

Risk of Listening to Advice, Chasing Performance

Taking your eye off the prize because, for a while, some other security is doing a lot better than VTI. But it never lasts. By the time you recognize a high performing security, it is at the end of its run and you will again , “Buy High and Sell Low”.

  • Trying to “beat the market”

    Regular investments in a single security is not cool. Not much to talk about (except the performance of your portfolio – which, more than likely is better than your peers). You may be tempted to change things up. Try something new. DON”T. There are no strategies that will accumulate more money in the long run than this simple plan that I have given you.
    .

  • Listening to “advice” from “professionals”

    Investors are the recipients of constant advice. Tips abound. Can’t miss strategies are all around you.

Losing Potential of Diversified Portfolio

You may not believe that VTI can outperform most diversified portfolios. You may not trust the examples I have presented. As I indicated, I’m sure there are diversified portfolios that outperform VTI but they are nearly impossible to construct. Many have tried, few have succeeded.

If you feel you must build a diversified portfolio digest the contents of this website, Index Fund Advisors.  It does an excellent job of presenting the case for a diversified portfolio . Index Fund Advisors is the only investment advisor I would listen to. Their advice is backed by solid research.  Remember, diversified portfolios have their own problems.

The key take-away

Because investing evokes emotion, success depends on a long-term perspective and a disciplined approach. Abandoning a planned investment strategy can be costly, and research has shown that some of the most significant derailers are behavioral: the allure of market-timing, and the temptation to chase performance and the temptation to quit when the market goes into the tank.

Far more dependable than what the market is doing at the moment is a program of steady saving. Making regular contributions to a portfolio, and increasing them over time, can have a surprisingly powerful impact on long-term results

Return To “Diversified Portfolios Examined

Return To “Why No Diversification

Return To “Evidence Based Proof of Plan

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s