Investing: Focus on your downside (You read that right)

One big lesson from the coronavirus pandemic is that risks abound and can show up seemingly out of nowhere.  Moreover, since risk is an ongoing issue for businesses, it’s an ongoing issue for investors.  However, when it comes to saving and investing for retirement, many of us tend to focus our efforts on achieving a higher return when it’s likely more profitable to focus our efforts on managing/limiting our risk.  Here are some ways to do so:   

 

Know yourself

Most people probably don’t have a good sense of their risk tolerance level until they are faced with a bear market.  However, to be a successful investor, it’s important to have a clear(er) sense of your risk tolerance level.   One place to start is with risk tolerance questionnaires.  (This is a fairly well-respected risk tolerance questionnaire developed by two personal financial planning professors, Dr. Ruth Lytton and Dr. John Grable.)  Still, how you assume you will react to a bear market can be very different from how you actually will react.  So, another (and likely better) way to gauge your risk tolerance is to reflect on your response to the last (few) bear market.  When in doubt about your risk tolerance level, however, consider defaulting to the more conservative assumption.  It’s difficult to accurately gauge your risk tolerance level, but there’s value in the process as it helps increase personal awareness.  

 

Diversify

Diversification is the holy grail of investing.  Not only does it help increase return, but it also helps limit risk.  Also, since no one can forecast the future with any degree of accuracy or consistency, it’s best to diversify your investments to ensure that when one segment zig, the other zag.  Here are three key areas in which to diversify:

 

1) Geography:  Many investors are prone to home country bias wherein they allocate a greater portion of their investments to companies from their home country.  This tendency is a by-product of greater knowledge in their home countries’ companies; lower investing cost; less currency risk.  While the typical investors hold an average of 15% of their total portfolio in international equities, research shows that the optimal amount is at least 30%.[1]

 

2) Market Capitalization:  This is a fancy finance term referring to the total value of the company based on its shares outstanding (or owned by investors).  Most companies fall into one of three categories: 

·       Small cap stocks:  Company’s total value is between $300 million and $2 billion dollars.

·       Mid-cap stocks:  Company’s total value is between $2 billion and $10 billion dollars.   

·       Large-cap stocks:  Company’s total value is greater than $10 billion dollars.

While large cap stocks represent about 91% of the US equity market (as measured by the Wilshire 5000), research shows that over the long-term, small cap stocks tend to outperform large cap stocks.  However, since performance leadership rotates through time, it’s best to hold some investments in all three market caps. 

 

3) Style – Value versus Growth:  Value stocks are sold for less than their true value based on the company’s earnings, sales, dividends, etc.  Meanwhile, growth stocks are those wherein the company is projected to grow more than the market average.  Over the long-term, value stocks typically outperform growth stocks.  However, in the interim, they usually take turns leading.  

To diversify adequately in terms of geography, market cap and style, consider researching further into possible total international market index funds and  total US market index funds.  

 

Dollar-cost average

There’s an ongoing debate about whether or not it’s best to invest via dollar-cost averaging or lump sum into the market.  Research shows that the latter often yields a higher return in the long run as you’re putting more money to work in the market sooner versus later.[2]  However, most people either don’t have a lump sum to invest or doing so feels risky.  (What if the market drops right after you invest a lump sum?)  As is, a hybrid strategy may be more palatable.  For example, if you have $100,000 to invest, consider initially investing a $50K lump sum and then dollar-cost average the rest (perhaps $1,000 every week) into the market.  Since money and emotions often walk hand-in-hand, it’s often best to choose a strategy that can balance the dueling need to eat well and sleep well.        

 

Time in the market

It’s often said that time in the market is more important than timing the market.  The main reason is that since the future is unknowable, it’s best to stay invested throughout the ups and downs.  Exhibit 2 illustrates the corrosive effect of market timing.  By missing a handful of the best return days, investors suffer a noticeable reduction in annualized return. Additionally, it’s important to keep in mind that you’re rewarded (via dividends) for continually being in the market and riding out downturns. 

 

Exhibit 2: Performance of the S&P 500 (1990-2019)

 Performance 

 Source: “Recent Market Volatility,” Dimensional Fund Advisors, 2020 

 

Final thoughts 

As often the case, Warren Buffet is able to distill great investment wisdom into a few simple words.  Risk and return are inextricably tied.  However, there are some key strategies investors can adopt to limit their downside.  If investors are not able to live through the downside, then they won’t be around for the upside – an apt reminder in the midst of a worldwide pandemic.