investing

Could Now Be the Right Time to Dial Down Your Investment Risk?

The stock market’s stunning turn of events recently could present a golden opportunity to rebalance your portfolio.

After the stock market began its plunge in mid-March, investors hurried to find out if their portfolios could withstand the steep drop and what to do next.  Now, several weeks later, we’ve all exhaled as the market has gradually recovered.

Fortunately, this scenario may benefit many investors, presenting them with a golden opportunity to re-allocate their portfolios to match their risk tolerance. This is particularly true for those who gradually increased their allocation to equities in recent years and then saw their portfolios collapse in March. Now, with the Standard & Poor’s 500 index only off 8.4% from its all-time highs as of June 30, it’s time for all investors to examine their tolerance for risk without having an uncomfortable discussion as the market is plummeting.

Historical Figures Reveal a Surprising Sweet Spot

This opportunity exists even as some investors wonder if they should double down on the markets’ recovery. They are concerned if they don’t have enough stocks in their portfolio, or the right stocks, they will miss out if the market races to a new record in the next 12 months.

But history shows us there is a “sweet spot” in any portfolio when we consider the trade-off between risk and reward. It may seem hard to believe, but it tends to be a portfolio that consists of between 50% and 60% stocks.

As an investor’s portfolio takes on more risk, with stocks making up 70%, 80% or more, returns can certainly increase as the market moves higher. But because their portfolio becomes less and less diverse, the investor takes on significantly more risk. And that’s what caused panic in some people a couple of months back.

A Clear Example of Risk vs. Return

A simple chart comparing the performance of three portfolios helps demonstrate the often-disproportionate relationship between risk and return. The chart below shows the performance of three different portfolios over a 5-, 10- and 15-year period.

It’s important to note that while the portfolio consisting of 75% stocks performed slightly better than those with only 60%, the difference is small. At the same time, the stock-heavy portfolio leaves little margin for error during a sharp downturn like the one we just experienced.

Over a 15-year period, it is no surprise that when looking at the rolling period with the best-case scenario, the portfolio with 75% stocks had the best returns, at 16.8%. Surprisingly, the more conservative portfolios – those with a 60/40 and 40/60 mix of stocks and bonds, were not far behind. The former gained 15.6% and the latter 13.9%. (Note: To see the full chart, you may need to use the scroll arrow. Depending on your device, it may be easier to view the full chart here.)

          
Historic Rolling Returns*
 75% Stocks/25% Bonds60% Stocks/40% Bonds40% Stocks/60% Bonds
Maximum Drawdown43.08%36.46%26.71%
Rolling PeriodBestAverageWorstBestAverageWorstBestAverageWorst
5 Years27.55%10.01%-3.34%24.92%9.53%-1.60%24.73%8.81%0.67%
10 Years17.47%9.75%-0.68%16.57%9.40%0.81%15.59%8.83%2.70%
15 Years16.79%10.01%3.76%15.57%9.66%4.13%13.89%9.09%4.51%
*information based on Ibbotson Large Cap Stocks and Corporate Bond historic performance from 1969 to present

However, proper retirement planning is not based on best-case scenarios. Looking at the same portfolios, the average 15-year rolling period showed annual gains of 10%, 9.7% and 9.1%, respectively.  Again, the portfolio consisting of 75% stocks and 25% bonds performed the best, but the difference between the three portfolios is quite slim.

This becomes especially important for investors with a shorter time horizon investing in today’s relatively expensive market.  An expensive market does not necessitate a crash, but it does heighten the risk of one.  Looking at the worst rolling periods tells us that even over 10- to 15-year periods, conservative portfolios may hold up better than aggressive ones.

What This Means for Investors Today

So, for those investors who believe now is the time to move a high percentage of their portfolio into stocks, you may want to think again. Our lesson from the data is simple: Do not make the mistake of assuming that a much riskier investment portfolio has the potential for a significantly higher return, even over a long period. There is no need to maintain a high-risk portfolio because of fear of leaving money on the table. The real-world differences in rates of return are slim, and in many circumstances can be negative. 

We don’t know what level of returns the stock market will produce going forward. However, we know the relationship between risk and reward holds remarkably stable over time and market conditions.

If the events of the last two months caused you to lose sleep or frantically call your adviser to make a change, now is your chance to make thoughtful changes to your allocation. At some point, there will be another event that will have an unfavorable financial impact. Will you be prepared when it happens?

For now, markets have made a strong step toward recovery, but the road forward is increasingly uncertain. If another crash occurs, no investor wants to find out they’ve taken on too much risk after another 30% or more drop; the next recovery may not come so quickly. Remember the goal is financial independence, not capturing every single penny of return at the expense of your mental health. 

The only benchmark you need to meet is the retirement date circled on your calendar. 

About the Author

Herman Freitag, CFP®

Associate Wealth Adviser, McGill Advisors

Herman Freitag is an associate wealth adviser with McGill Advisors. Prior to joining McGill Advisors he was with a national investment firm serving high-net-worth clients for four years. Previously he had worked for the private banking and retail arms of a national bank for four years. He earned his CERTIFIED FINANCIAL PLANNER™ professional certification in 2017. Herman is a native of New Orleans.

Most Popular

When Could We Get a Third Stimulus Check?
Coronavirus and Your Money

When Could We Get a Third Stimulus Check?

President Biden and others in Congress are pushing for a third-round of stimulus checks, but it might be a while before we get them.
January 20, 2021
Where's My Stimulus Check? Use the IRS's "Get My Payment" Portal to Get an Answer
Coronavirus and Your Money

Where's My Stimulus Check? Use the IRS's "Get My Payment" Portal to Get an Answer

The IRS has an online tool that lets you track the status of your second stimulus check.
January 18, 2021
20 Best Stocks to Buy for the Joe Biden Presidency
stocks to buy

20 Best Stocks to Buy for the Joe Biden Presidency

Joe Biden has been sworn in as America's 46th president. These are 20 of the best stocks to own under the new administration.
January 20, 2021

Recommended

What Could 2021 Hold for Your Finances?
retirement planning

What Could 2021 Hold for Your Finances?

After a wild 2020, many of us are ready for a fresh start in the new year.
January 22, 2021
Don’t Have a Pension? The SECURE Act Could Help
retirement planning

Don’t Have a Pension? The SECURE Act Could Help

If you’re worried about retirement, the SECURE Act has a lot to offer. It has several provisions to allow people to save more, for more years — and it…
January 22, 2021
4 Reasons Retirees Should Care About the New Coronavirus Stimulus Package
Coronavirus and Your Money

4 Reasons Retirees Should Care About the New Coronavirus Stimulus Package

Yes, the possibility that you’ll get a stimulus check is definitely something to care about, but there are other aspects of this act involving taxes a…
January 21, 2021
Unhappy with Low CD Rates? A Structured Note May Be the Answer
retirement planning

Unhappy with Low CD Rates? A Structured Note May Be the Answer

What are structured notes? How do they limit risk while allowing for gains? Considering their pros and cons, could a structured note be right for you?…
January 20, 2021