Quantify the risk in your portfolio

Picture this: It is 1981 and you just got married, landed a stable job and found your dream home in the perfect neighborhood. You and your spouse could not be more excited about life considering you just locked in a 30-year mortgage at 16%. What a deal! Just a few months ago, it was 17%, and you just saved $100 per month on your mortgage payment.

The next day, you join your parents for a Sunday supper and your old man gives you some financial advice.

“Son, make sure you deposit any extra savings into a portfolio of 60% stocks and 40% bonds. If you cannot buy bonds, just go to your local bank and purchase a Certificate of Deposit (CD). Once you have $1 million saved, you should be able to retire comfortably and live on the income that your bonds or CDs pay you while participating in the market gains from the stocks.”

Sounds easy, right? Well, those were simple times and it worked well over the past 40 years. Dad had good advice — and, at the time, made sense considering the Dow Jones Industrial Average closed at 875 points that year (compared to 32,500 today as I write this) and the 10-year Treasury note hit an all-time high of 15.84% (compared to 1.5% today). This was during a period where the six-month CD peaked at 17.98% in August 1981. Using that rate, a $400,000 investment paid an investor $35,960 in interest after 6 months. That is not a bad return on investment, and Dad’s advice was hard to argue with.

Fast forward to today and you’ve now reached the million-dollar mark in savings. It is time to start thinking about when to retire, and you recall your Dad’s advice about living off the income from the bonds and CDs. Well, the same six-month CD today is averaging around 0.35%. A $400,000 investment into a 6-month CD now returns only $700. It is a little harder to grow your wealth and retire on that. Combine this bleak computation with the fact that the stock market is at or near all-time highs, and many investors are having a hard time putting 60% of their investments into stocks. This leads to a question that many investors are asking: Where should I park my money for a while until the market settles down?

This is one of the most common questions that I receive, and the answer is not as easy as it used to be. Back in the good old days when interest rates were much higher, investors could ladder a portfolio of income-producing securities and provide a 6%, 7% or 8% return. Today, those same types of securities with similar credit quality and maturity dates offer a measly 1%, 2% and 3% return.

Additionally, the markets are much more complex and volatile. There are more products and choices than ever. According to CUSIP Global Services, there are more than 60 million financial products globally, including stocks, bonds, mutual funds, ETFs, UITs, commodities, hybrids, structured products, and derivatives — just to name a few. When I get a question like this, I often pose the question with another question: What is your time horizon and risk tolerance, and have you ever quantified it?

The answer to the latter question almost always is “no.” This baffles me, because our personal health has been quantified by professionals our entire lives. Why don’t we do this with our personal finances? From the second we are born, nurses are checking vital signs — closely monitoring body temperature, pulse rate, respiration rate and blood pressure. Each annual physical includes a variety of similar tests as well as an opportunity to ask questions of the doctor and discuss any ongoing issues or concerns. If a medical emergency occurs, we are rushed to the hospital and those same vital signs are immediately checked, and a doctor makes an educated and professional decision whether or not surgery is needed.

Our financial health throughout our lifetimes often is a much different experience. Most kids do not talk about cash flow or asset allocation at the dinner table with their families. Schools across the country generally do not teach personal finance. Once we become adults, the topic of personal finance often is foreign. We have a do-it-yourself (DIY) mentality, and key financial vital signs often are misdiagnosed. Unfortunately, many investors make emotional decisions and funds are misallocated based on their own biases or because “that was the way my Dad did it.”

Investors have been stereotyped for decades based on their age and put into a box to identify their risk tolerance — aggressive, moderate, or conservative. Fortunately, this qualitative approach has evolved as technology has helped investors define their needs, wants and wishes. Tools have been developed and the evolution of how to quantify risk can be assessed appropriately and a portfolio can go from cookie-cutter to customized.

I would suggest working with a financial adviser who can help you identify your risk based on your time horizon — a quantitative way to pinpoint how much risk you want and how much risk you need to take to reach your goals, and how much risk you actually have in your portfolio. Working with a trusted adviser can help guide you to quantify your risk tolerance, as well as ensure you stay on course to achieve your long-term financial goals.

Ryan Diepstra is a principal and COO at Centennial Securities. He can be reached at ryan@centennialsec.com or (616) 942-7680.