How Northstar Thinks About Risk
As the market continues to regain steam and approaches its highs from 2021, we believe it may be a good time to talk about the concept of risk in investing. While the risk involved in investing may be most acutely felt when the market is declining, that's generally not when investors are in the best frame of mind to assess whether their portfolio has an appropriate level of risk for them.
Risk is an unavoidable part of investing. The choice to buy any investment (stock, bond, gold, Beanie Babies, etc.) comes down to this question: Will the returns I could receive adequately compensate me for the risk I’m taking.
It’s common for new investors to assume that the reason they would hire an investment advisor or portfolio manager to invest their money is so they can get higher returns. We believe that’s a fallacy that can set you up for disappointment, anxiety, or possibly lead you to pay exorbitantly high fees in the name of chasing returns. We believe that the value of an investment advisor is to help you balance risk and return according to your specific needs.
We raise the topic of risk with our clients early and often because we consider risk tolerance to be a key component of the investment strategy we establish for each client. When Northstar chooses an investment strategy for a client, we aim to achieve the highest return for the level of risk they’re willing to take. That’s based on a concept called the “efficient frontier”, introduced by Harry Markowitz as the cornerstone to his Nobel-prize winning modern portfolio theory (MPT).
We’re big proponents of MPT, because it’s evidence-based and has stood the test of time and encourages taking a personalized approach to each situation. As you can see from the definition, the concept of risk is central to MPT. No one can eliminate risk from investing and anyone who says they can is lying. We have to understand each person's risk tolerance in order to use MPT to develop the portfolio that can earn each client the returns that are possible given their specific risk tolerance.
Let’s make this concrete
The risk tolerance questionnaire we use for new clients has this question on it:
It’s tempting to choose Portfolio E as the optimal portfolio because it’s hard to see past that 50% “Best-case return” – but consider how you would feel in the midst of a 28.2% decline? Would you have the flexibility to leave your funds in the market for long enough to recover those losses? Putting numbers to the potential volatility of a high-return portfolio can make that challenge of balancing return and risk more concrete and drive home the importance of paying just as much attention to the risk involved in investing as to the returns.
What’s the harm in having a portfolio that doesn’t match my risk tolerance?
First, stress and anxiety have a real impact on your health and there are enough things to stress about in life. Adding stress induced by the financial markets to your already stressful existence could have a real impact on your health. If you’re already raising two teenage boys like Charlotte is, that could put you over the brink.
Second, because you have your best chance of realizing better returns if you keep your money invested over a longer time horizon. If a portfolio’s risk factor exceeds its investor’s risk tolerance it will be harder for that investor to stay the course when the market is down.
If you can't keep yourself from pulling your money out when your portfolio is down then it’s possible your portfolio has more volatility than you can bear, and you should think about readjusting to fit your true risk tolerance.
If you’re an investor, we encourage you to embrace the concept of risk because it can help you get to the specific investment strategy that works best for you over the long term. We hope you have an investment advisor who can help you think through that, and if you don’t, give us a call.