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Understanding your unique perception of risk

Investment risk comes in many forms and is talked about so frequently within the industry, that every type of risk has it’s own name. Just a few are longevity risk, inflation risk, interest rate risk, liquidity risk, political risk, and market risk. This post is not about the risks themselves, rather, it is about the factors that affect our response to the risk and why it may differ from our spouse’s risk tolerance – It’s what contributes to your unique perception of risk.

Usually, when spouses disagree over how aggressive or conservative they want to be with their portfolio, the disagreement can boil down to a few key factors that can influence risk. Below are a list of some of the most common factors that influence our feelings toward risk in general.

Trust: The more trust an investor has in their financial plan, their advisor, the markets, their specific holdings, etc, the less afraid they will be.

Risk/benefit: investors who can weigh the benefits of taking on certain level of risk., the investor may be less fearful of the perceived risks if the perceived benefit outweighs the risks. Millions of people living along the ocean are taking a risk of having their homes flooded. And yet they are highly desirable pieces of property.

Control: The more control or the feeling of control an investor has over the outcome, the less likely they are to be fearful.

Choice: Risk that is imposed on us tends to cause more fear than risk we chose for ourselves.

Uncertainty: This comes as no big surprise, not knowing the likelihood of the risk occurring can cause more fear than actually knowing the likelihood.

Natural/man made: Risk related to a natural event (storms, floods, snow) tend to cause less fear than man-made events (wars).

Horror: The scarier the event, the more fear it causes. A traumatic death is much scarier than a death caused by a sudden heart attack.

Catastrophic/Chronic: Temporary events that cause lots of damage to a small population causes more fear than small amounts of damage caused over time to a large population. Think about how much more damage is caused by pollution or heart disease, and yet we are more afraid of a house fire, car accident, or terrorism. Many investors are more concerned about the sudden market drops, yet completely unaware of the bigger and ever present issue of inflation.

New/familiar: A new risk tends to cause more fear than a risk we’ve been subject to for years. Over time and with more experience and familiarity, the fear of the risk can subside.

Personalization and fairness: risks that affect people we know, children, the poor or the vulnerable tend to evoke a strong negative response.

Awareness: Lastly, simply being aware of the risk raises the level of fear. Knowing that it could happen after reading about it in the news, tends to elevate fears.

These perceptions are constantly changing based on our experiences and as events unfold. As you read this, you may find yourself thinking that a few of these perceptions affect you more than the others, but a whole new set of perceptions could become important if the markets changed.

It is our experience that many of these perceptions have a negative effect on investment decisions. All too often, these perceptions cause investors to sell out at the bottom of a temporary market decline. Investors make their decisions out of fear and emotions rather than facts. Understanding the root cause or key characteristic that drives investor fear and then finding a way to overcome and solve that fear is the first step a fearful investor should take when thinking about getting back into the market.

 

How can a positive news cycle impact the markets?

The news cycle, which usually is designed to stoke investors’ fears and panic, is actually turning more positive now. The storylines are changing to observations of “a slow but continuing economic recovery”.

We need the psychology to change to the positive to make up for the ongoing bad news out of Europe, and as PIMCO’s El-Erian says, to offset the “headwinds of Congressional dysfunction”.

Economic Momentum

Hopefully, this news cycle can help repair investor confidence.

Misperceptions of Risk

Below is the outline of a recent talk given by Nick Murray. For those unfamiliar with his message, it is one of extreme optimism. He is renowned within the industry for his ability to look past all the noise and point out the truths of why now is the best time to invest… in a rather direct and blunt approach.

Investing is easy. there are only two outcomes:

1) You will outlive your money.

2) Your money will outlive you.

It’s that simple.

Investors have two misperceptions of risk:

1) Investors are concerned about loss of principal.

why is this a misperception?

The real concern is loss of purchasing power NOT principal.

Purchasing power is inflation.

3% inflation rate over 30 years of retirement means that you will need $125,000 in 30 years to buy $50,000 worth of goods in today’s dollars.

The problem is erosion of purchasing power.

Every year, everything you need to buy will cost more.

Investors can not invest in a retirement they can’t imagine.

To solve this problem, investors need rising income to account for inflation.

Fixed income is like a rattle snake, it warns you before it bites. It’s fixed like the name implies.

Solution: invest in the great companies both domestic and foreign and own for the rest of your life. The dividends produced rise over time and may help reduce inflation risk.

2) Investors can’t distinguish between volatility and loss

All too often, investors mistake temporary declines for permanent loss and sell out before it returns.

Why is this a misperception?

Stock market is not the source of all ruin

Most parents of baby boomers were born during the depression and the baby boomer’s thoughts on the stock market are based on their parents perceptions of the market.

News does not equal truth

News does not think in 30 year clips

Solution: turn off the TV and stop listening to the noise.

 

Tweaking a Buy and Hold Strategy

One of the most common investment strategies is called “Buy and Hold”, which usually consists of mutual funds or other securities held for the long term and rebalanced occasionally.  These funds are held during the best and worst performing years.  The theory is that you can never predict the future performance of the market or time your trades to sell at the top or buy at the bottom. Instead you ride the waves, knowing that there will be ups and downs.

After the recession of 2008 and 2009, the “Buy and Hold” strategy started to lose favor.  Investors could not tolerate such significant declines in their portfolio. It caused many investors to give up on their strategy, sell out of their portfolios at the wrong time (the bottom) and move to cash to wait for better days, more optimism and more clarity.

And so they sat. and sat. and sat.

Here we are, four years later and the S&P 500 has now returned a total of 130% (3/9-12/12). There is a pattern here. American Funds released a newsletter that has a chart on page 2. It highlights the returns for the subsequent 10 years following the major declines of 1939 and 1974. The returns for those two ten year periods were in the 15% range, well above the 11% average for the S&P 500.

It turns out, this sort of return is not unique when compared to historical performance.

For those investors that stayed invested, they are watching their portfolios return to previous levels and grow even more. But, unfortunately many investors are still sitting on the sidelines wondering how to get it.

Maybe “Buy and Hold” is not dead after all!  Although, it may not be right for everyone.

If you are one of the millions of investors who sold out close to the bottom and still reluctant to get back in, consider these strategies:

1 – Limit the amount of news you watch. So much of it is noise and simply a distraction.  Take it with a grain of salt.

2 – Periodically review your statements and make calculated decisions.  It’s easy to react quickly if you see a bad news report and then review your statement.

3 – Keep the course.  Despite all the voices in your head that tell you to sell, hold on to your strategy. It may be hard, but that’s why you have a strategy in the first place.

4 – Stay diversified.  Invest in different asset classes to spread your risk out.  If you are holding too much in one specific stock or mutual fund, consider moving some of it elsewhere.

5 – Consider dollar cost averaging.  If you’re trying to time when to get back in the market or when to make contributions, dollar cost averaging may help.  With most fund companies and broker/dealers, you can establish rules to invest a specific amount each week/month. That may reduce the risk of buying a security only to see it drop shortly after you purchase it. It allows you to ease back into the markets, instead of jumping in.  Keep in mind, this method does not ensure a profit and does not protect against loss in a declining market, so investors should consider their willingness to continue purchases during a declining or fluctuating market.

6 – Get help. It is becoming more and more complicated to invest with more options and increasingly complex products that may not be right for you unless you talk to a professional.

But if you read this, and you feel that even with those changes, you can’t stomach another decline like before then you may need a new strategy all together.  We had several client that express their concern and have developed a model portfolio to meet their needs. It looks to capture profits when trends within a variety of asset classes are positive and sit in cash when the trends are negative.  You can read more about it here.

Are You Addicted to News?

A recent article by the Guardian discusses 10 reasons why news can harm you. It’s an interesting read, one that reinforces a message that we regularly communicate to our clients: news is sensationalized to draw viewers but it should be taken with a grain of salt and not relied on to make investment decisions without doing your own research.

The article references the sensational and shocking stories we see. These stories are designed to scare us into doing something (or not doing something). The article fails to recognize, that there is a lot of insightful, objective, and thoroughly-researched journalism produced every single day that readers should be reading. Length does not necessarily indicate quality. Long articles can be sensationalized just as much as a tweet. And a tweet can be more insightful than a long article.

The problem becomes: How to determine quality news from an eye catching headline with regurgitated content. Second, where do we find quality news and who can we trust?

We will cover those questions in a later post.

 

A Golden Age

It’s easy to forget and lose perspective about what is happening in this world. From uncertainty in our economy and in Europe, the looming fiscal cliff, and most recently the tragedy in Newtown, we may be feeling lost and unsure about the future. Just turn on any news program. The pundits, news anchors, talking heads, supposed experts, and politicians are talking about the problems we face.

But let’s not forget some amazing accomplishments that have occurred in recent years:

· People throughout the world are now living longer than ever before, here.

· Extreme poverty has been dropping year over year, thanks in a large part to the improving economies in Asia, here. . (For a fascinating comparison of population size and prosperity over the past 200 years, visit here. )

· The cell phone is playing a huge part in reducing poverty. “A 2010 U.N. study, for example, found that cell phones are one of the most effective advancements in history to lift people out of poverty.” Time Magazine.

· Global food production continues to increase, here.

· GDP per capita has been rising throughout the world, here.

· Scientific and technical journal articles have been increasing each year, leading to more and more health and science breakthroughs, here.

· On a global scale, people are building and inventing more new technologies than ever before. Patent applications have been rising each year, here.

· Deaths related to battles, conflict and wars are showing a downtrend, meaning there are fewer death than ever before due to conflicts, here.

· For more trends that point to an improved and improving world visit here.

“Never has there been less hunger, less disease or more prosperity. The West remains in the economic doldrums, but most developing countries are charging ahead, and people are being lifted out of poverty at the fastest rate ever recorded. The death toll inflicted by war and natural disasters is also mercifully low. We are living in a golden age.” (link to full articlelink to full article)

The above article is a fresh perspective and provides a positive view of a world that many are unsure about. The fiscal cliff just doesn’t seem as important now as it did a few moments ago.

We hope that you have a wonderful holiday and when you have a conversation with family or friends that delve into what this world is becoming, think back to this newsletter and all the good things that are happening.

Maybe we are living in a golden age and we can’t see it.