HOW TO MANAGE RISK IN INVESTING
When stock markets fall and there is a great deal of volatility in the equity markets, investors take a closer look at investment risk. When we are in a bull market, investors are not very concerned about risk. When we are in a bear market, and we see our portfolio drop frequently in value, reality forces us to recognize that real investment risk.
In November 2018, I favorably reviewed a book written by Howard Marks, a successful manager of
Oakmark mutual funds. In the book, “The Most Important Thing,” Marks devoted three excellent chapters to the issue of risk. I have read hundreds of investment books, but this is the only book I have read that devoted so much of it to risk management.
I recently reread the book, and his discussion of risk encouraged me to write this column. John Bogle reviewed the book and wrote, “If you seek to avoid the pitfalls of investing, you must read this book.” I agree.
Marks points out that different investors look at risk differently. For example, the manager of a pension fund might need an average return of 8% per year to meet its pensioners’ obligations. Ordinary retirement investors can be more conservative. Marks believes “recognizing risk often starts with understanding when investors are paying it too little heed, being too optimistic and paying too much for an asset. ... High risk, in other words comes primarily with high prices.”
In a recent CNBC interview, Marks said, “It took seven years to get back to the 2000 highs in 2007. It took 5 1⁄ years
2 to get back to the 2007 highs in late
2012. So, is it really appropriate that, given all the bad news in the world today, we should get back to the highs in only three months? That seems inappropriately positive.”
Recently, Warren Buffett was positive about future long-term prospects of the economy. However, he is holding billions of dollars in cash and hasn’t committed to any new investments. He also recommended investors use the S&P index fund for equity investing.
I think the takeaway from Marks’ comments and Buffett’s decision to hold off reinvesting now is that investors should be cautious about new equity investing.
I recently wrote that investors with a significant cash holding could start reinvesting gradually in index equity funds, using “dollar-cost-averaging” perhaps over at least a one-year time frame. I think Marks’ and Buffett’s comments and cash holding support this position.
Most investors have seen their portfolio fall significantly since the end of 2019, and based on the mail I receive, many are nervous about their portfolio and are not sure what, if anything, they should do. One thing you can do is reevaluate the optimum ratio of stocks to bonds in your portfolio, taking risk into consideration.
Don’t be close-minded when it comes to determining a stock-to-bond ratio. I have used different allocations based on different life stages. When I started investing, I maintained a high stock-tobond allocation, investing almost 90% in equities in my 20s and 30s, and 70% in my 40s and early 50s. I believed then, and now, that at the beginning of a career, an investor can take more risk, and invest a higher percent of investments in equities.
By the time I retired (at 58), my allocation was pretty close to 50-50. It is too risky to have a large percentage of your portfolio in stocks, especially at the start of retirement. It’s hard to recover from a significant drop in equity prices at the start of retirement. However, it is important, even during retirement, to maintain a significant percent of stocks in order to protect against inflation.
I have been retired now for over 20 years, and I still maintain approximately 50% of my portfolio in diversified equities, mostly index funds. I can take some risk because of a generous pension and Social Security.
Individuals without consistent guaranteed income should consider an equity position less than 50%. Rebalance at least annually. By doing that, I have retained a great deal of the increase in equities during the long bull market.
Elliot Raphaelson welcomes questions and comments at raphelliot@gmail.com.