With the ups and downs in investing over the past three plus years, many investors tolerance for risk has changed. Unfortunately, their attitudes towards risk usually are in the wrong direction depending on the trend of stock prices.
Many work up the courage to buy what has done well recently and ignore what has performed poorly. This is evident in numerous studies of what investor’s returns are compared to the index returns. A 2011 Dalbar study found that for the twenty-year period, equity investors earned 3.83% and asset allocation fund investors earned 2.56% compared to the S&P 500 return of 9.14%. For the same period, fixed income investors earned 1.01% compared to the Barclays Aggregate Bond Index return of 6.89%.
When answering a risk profile questionnaire, it is easy to pick answers based on your current feelings and what has recently happened with stocks. This is a poor way to determine your risk profile because it doesn’t produce a true reflection of how much risk you are willing to take.
Here is a typical scenario: An investor lost 40% or more during the financial crisis in 2007 and 2008 and was worried sick. They decided to become more conservative by selling stocks and buying more bonds. Then the market bottomed in the beginning of 2009 and stocks went up 100% in two years. The investor looks at their relatively lower returns during that period and decides to buy stocks again. They don’t realize that stocks move in cycles and to buy now means buying when stocks are much more expensive than they were in 2009. Now is the time to be defensive and wait for opportunities to buy discounted prices.
A more appropriate way to make purchasing decisions is to maintain a consistent risk profile that takes into account a maximum loss in one year’s time. Rebalance to your stock, bond, and alternative asset targets once or twice a year and reap the benefits of buying when prices are low.
