2020 Foresight: Risk is a necessary part of life

“Optimistic people play a disproportionate role in shaping our lives. Their decisions make a difference; they are inventors, entrepreneurs, political and military leaders—not average people. They got to where they are by seeking challenges and taking risks.” —Daniel Kahneman

Risk is often thought of as a “four-letter word,” misunderstood and maligned. Yet it is tough to accomplish anything worthwhile in life without it. Risk is an especially pertinent topic relative to markets these days given the amplitude of worrisome headlines and late-cycle nature of both the economic and market expansions. Fears of a recession lead many to believe they can jump out of markets ahead of time with the presumption that economic and market downturns are coincident, which has historically not been the case. Numerous studies have shown market timing to be unproductive. The process involves being right—on a tax and cost-adjusted basis—on both the sell and the buy transactions. 

From a behavioral finance standpoint, the constant barrage of negative headlines can leave us in a dour mood and desirous of taking action in an attempt to avoid volatility, which is often perceived as the #1 risk. But long-term successful investing is a discomfiting activity by definition. It requires staying power, and an ability to recognize and capitalize on unrecognized value disparities; to be able to sell when others are buying and buy when all the herd is looking to sell. The key to having staying power, both psychological and practical, is to clearly define the true risks most pertinent to your specific situation, insulate your financial wherewithal to incorporate those risks, and prepare your psyche with a healthy dose of visioning and prep work to enable you to maintain perspective when headlines get overly bullish or overly bearish. 

Identifying true risk

Each of us has a different tolerance for specific risks. Further, our risk-absorbing capacity may shift throughout our lives as our financial and time frames change. Core risks include:

Permanent loss of capital. (Not downdrafts that last a day, a week, a quarter, or even a year or two). Those with staying power and the wherewithal to lean into downdrafts are typically well-positioned for long-term growth—in the same way, companies with clean balance sheets and solid cash flow can often buy competitors that are less well-capitalized when the economy is wobbly.

Loss of purchasing power. Ironically, trying to minimize risk too much can lead to lack of growth and the inability to outpace inflation. Keep in mind that while headline inflation as measured by the CPI has been very low for years, inflation in things that facilitate quality of life (food, energy, health, and education) has been much higher than “average.”

Lack of sufficient liquidity to fund ongoing or specific needs.

High costs. Either taxes or transaction, the result of poor asset location or inelegant planning.

Specific moves to consider

While market timing doesn’t work in your favor and staying put for long hauls typically does, there are moves you can undertake to help make choppy markets “feel” a little more comforting. 

• Consider carving out (perhaps even in a separate account) assets that need to be decked against specific needs, e.g., 3 years’ spending, the next X quarters’ tax payments, funds needed for an offspring’s education, vacation, property taxes, etc. 
• Consider paying forward on multi-year charitable contributions (of course you’ll need to consult with your accountant and lawyers on this to synch amounts with income).
• Consider paying some lifetime bequests you have written into your estate planning documents <now,> while you have a chance to see your funding put to good use.
• Line up a credit line on your account to prevent having to sell securities during a short-term downdraft (e.g., tax payments that were pulled in 4Q 2018, for example when markets had pulled back nearly 20 percent before rallying a like amount a few weeks later).
• Rebalance regularly by trimming outperforming asset classes and rounding up allocations in classes that haven’t borne up as well yet.
• Turn off the financial media. Headlines are only going to accelerate toward the even more negative. We nearly into 2020, when presidential election rhetoric, ads, and angst will truly kick into high gear.

Stock markets have a way of powering through optimistically, and the very long-term trend has been upward. For example, when I began my career in the early 1980s, the DJIA had just crossed the 1,000 threshold. This is not to say that there are not periodic drawdowns that are gut-wrenchingly brutal (every year tends to have a drawdown of more than double-digit magnitude). But for those who can lean into a drawdown, short-term market volatility is risk. It may, in fact, represent opportunity to rebalance, reposition, or deploy sidelined cash.

Bottom line

Risk is a personal topic, but one well worth exploring. Understanding what risks you can take and having a plan to provide as much buffer as you can around those risks to your personal well-being should leave you well teed up to go confidently into the future.

 Carol Schleif, CFA, is deputy chief investment officer at Abbot Downing, which provides products and services through Wells Fargo Bank and its affiliates and subsidiaries. She welcomes your questions and comments at carol.schleif@abbotdowning.com.