When it comes to the way we handle tactical asset allocation, our decisions are often emotional and are affected by our fears of investment risk
When building a diversified portfolio, our fear of financial risk may be greater than we think
Successful investing often involves creating a diversified portfolio by using successful techniques in tactical asset allocation. This essentially means combining a certain proportion of “safe” investments that pay regular dividends with other investments that carry with them a certain amount of financial risk. The exact proportion depends on your personal circumstances and what your financial adviser suggests. However, if you were to conduct your own risk tolerance survey, you would probably find that though many people can accept this idea intellectually, they may end up changing their minds when they sign the dotted line due to their fears of market risk.
The story below illustrates this fear of investment risk perfectly.
I recently met with a client who was investing for the long term. In addition to her pension plan, she also had an IRA (Individual Retirement Account). We spoke about purchasing REITS (Real Estate Investment Trusts) and about how they would add diversification to her portfolio. We also looked at the benefit of dividend income. This way, her principal could have the potential for growth and she could sit back and let the dividends roll in.
However, several days after buying the REIT (which trades like a stock on the stock exchange) she called wanting to sell the position she had purchased a week earlier. I asked what motivated her to trade and she said that she calculated she’s already made a profit and wanted to lock in her gains. “But I thought you said that you wanted a portfolio that was a bit more aggressive and long term. And what about waiting for the highly anticipated dividends?” I asked.
However, she remained insistent on selling and collecting her profit.
The next day, as the stock dropped back down, she called again. “I’m happy I sold, since I made a profit. But I still believe in the company’s strong fundamentals. When do you think I should buy back?” This question led to a long discussion about market timing. Though you may sometimes guess right… buy low and sell high… can you do that with every trade? No one can. Not even the best professional investors with the most sophisticated trading platforms.
Sometimes investors are as unpredictable as the market
At times, individuals may be even more volatile than the market. Risk tolerance feels different when checked off in black and white on an account-opening form than it does when your stock is climbing…or falling. And sometimes clients don’t know their true tolerance until their portfolio changes in value.
Have a frank discussion with your financial planner about how you would feel if you made—or lost—real money. Determine how you can best design your portfolio to meet your real investing personality, not what you think you “should” do or what your neighbor is doing. On the one hand, there’s no need to check your stock’s price several times daily; on the other hand, though, you should not ignore your portfolio for months on end. Like everything else in life, find a balance.
Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.