Several years ago, a couple came to me for financial planning advice – let’s call them Jack and Jill. Jack had met Jill in the 1970’s when they both worked for the same company. Jill’s section of the company was eventually divested, and she continued to work in the new spin-off company. Over the decades, Jack and Jill took advantage of opportunities to buy company stock at discounts through their employee benefit packages. Consequently, as they entered retirement, they owned quite a bit of stock in the companies they worked for, in addition to substantial holdings in other companies that had their beginnings as branches of the larger, original company. While their holdings were diverse within the telecommunications industry, Jack and Jill had almost all of their assets invested in this single sector.
As I presented their financial plan, I strongly recommended that Jack and Jill sell most of their telecom stocks and diversify their holdings into other industries. I met emotional resistance to the notion of selling the telecom stocks. The stocks had performed so well for them that my clients refused to discuss the idea of moving any of their money out of telecommunications. I just couldn’t let it go. I kept coming back to the need to further diversify their stock portfolio, but each time I met further resistance from Jack and Jill. Jack finally had to tell me, “Look, Joe, this is our money and we want to keep our telecom stocks.” He wasn’t smiling.
Jack was right about one thing. It was their money, so we left their stocks heavily over-weighted in the telecom sector. Time went by. I relocated to Virginia and then to Texas, often reflecting on the confrontational nature of that part of the meeting. I thought of them very often in 2000 and 2001 as I watched telecommunications take the hardest beating that I have ever witnessed in a single sector. Although I don’t know when or if they were ever convinced to sell, I do know that if they held the same portfolio five years later that they held when I worked with them, their life-long investments lost 80-90% of their value during the market downturn. I would dearly love to know if they sold one of their primary holdings at $86.00 a share or $0.76 a share, but I don’t want my call to come across as an “I told you so.”
If the Family Feud surveyed 100 investors and asked them to name the single most important characteristic of an investment portfolio, I would wager that diversification would be among the top answers. “You have to diversify your portfolio.” “Don’t put all of your eggs into one basket.” These are common phrases in the investment field. People know that diversification eases volatility and that as diversification increases, capital risk decreases.
So my question is: if diversification is so well known and accepted, why aren’t more people practicing its principles? Why do so many investors overindulge in “hot buys” and sell off their losers to buy more of their gainers? Why do subtle market tremors cause otherwise rational people to make rash and bad decisions regarding their assets? Why do people invest heavily in stocks when they are on their way up, but sell them all and run for safety when the prices tumble?
It is well known that individual investors tend to actually realize a much lower rate of return on their investments than market averages. For many people – and I would guess most people – investment management is partly an emotional process. Asset selection is often based on emotional or sentimental biases, what we might call strongly-held wrong opinions. The decision to buy or sell a stock is frequently an emotional reaction to either the fear of losing money or the fear of not making enough money where there might be a chance to make more. Fear is an emotion, and it does not usually induce intelligent behavior.
Risk is a dynamic force that plays on powerful senses. To increase risk is to stimulate those senses, and even the most stalwart investor is bound to react emotionally with at least a quickened pulse or a heightened fear factor. Both losing money and missing opportunities to make money can bring on feelings of guilt, inadequacy and remorse. On the other hand, picking a winner strokes a satisfying, sustained chord that can resonate for a long, long time. Managing risk is the most important part of investing. Without risk, money won’t grow well, and most investors won’t earn high enough returns to meet their financial goals. However, risk brings uncertainty, and uncertainty also involves a chance that investors will not meet their financial goals. This is the basic conundrum that makes investing difficult, emotional, and interesting.
Risk is uncertainty, but a little uncertainty may be what you want if you are otherwise on a steady march toward a retirement in poverty. For example, suppose Austin, a young blue-collar worker earning a moderate salary, consistently set aside a small portion of his wages in an investment selected because it is almost devoid of risk. Of course, Austin’s investment will yield low (and probably taxable) rates of return. Since there is no risk, there will be little or no growth, and after taxes, costs, and fees, Austin’s real purchasing power may even dwindle over time. Austin’s investment strategy is one devoid of risk. In other words he can be 100% sure (notice the absence of risk) that he will retire poor. If he instead is willing to accept some risk in his portfolio, uncertainty (risk) is introduced. Now there is a chance that he will retire either poor or wealthy. So this is Austin’s dilemma: if he avoids risk he will not achieve his goals, and if he accepts risk, his investments may fluctuate but he is more likely to attain his financial dreams. With a little education and a peek at some projections, Austin may be more willing to re-evaluate his risk preference.
Before we can discuss managing risk in a meaningful way, I have the unhappy responsibility of telling you that we first need to spend some time defining it. Risk is a measure of the uncertainty of our projections of the future. Stated simply, risk is the reality that companies, real estate ventures, economic climates and just about everything else can fail or can perform differently than we expect. Risk comes in many forms and each type of risk creates a unique challenge to an investor. Fixating on reducing one form of risk usually leaves you exposed to another type of risk. For example, if investors allocate their portfolios to reduce the possibility of losing principal, then inflation and interest rate risks may become more problematic. Understanding the different types of risk and how to harness them is the first and most important step to asset management.
Please don’t become disheartened. The risk problem is complex and to some extent very boring to anyone other than a financial planning nerd like me. Our firm is designed to help guide you to a simple solution to this complex problem. But, before you can buy into the solution, you need to fully understand the problem. You need to fully embrace the solution because it involves strategically doing the opposite of what your emotions would otherwise tell you to do. Think of it as steering when skidding on ice; you need to turn the wheel in the opposite direction of the direction you want to go. In order to actually do that when crunch time comes, you need to trust in the strategy. Remember, most individual investors lose or at least don’t win the investment game. So you will need to behave differently than the average investor.