In parts 1 and 2 we identified and analyzed a number of risks associated with achieving our long-term goals that pertain mostly to reaching some form of financial freedom.
Risks associated with income generation (employment or other forms of incoming revenue related to daily work) and as a corollary, any savings after lifestyle expenses are covered, can be mitigated by various forms of insurance. We shall save this for a future blog, where we can draw on the expertise of a trusted professional or two.
Suffice it to say that I have witnessed the success of some whole life insurance policies issued many years ago that are, today, looking very strong in the diversification of assets and reduction of taxes categories (retirement and estate planning). Never considered “cheap”, but always worth considering in a long-term plan, especially when you are young and healthy (because you won’t always be so and insurance gets significantly costlier as you age).
In order to grow our money (savings) beyond regular contributions after lifestyle costs, we are going to need annual returns better than the annual increases in those costs (inflation).
That puts all the pressure on our investment portfolios. So lets look a little closer at how we assess (evaluate) the risk in our investment portfolios: Each security we own has a history of price movement. Larger moves in the price of that security, over time, can be measured to allow us to understand the role that the specific security will play as a function of the total portfolio given a certain amount of price appreciation or depreciation.
The measurement of price movement is referred to as the standard deviation away from its mean (average). So that a more volatile (historically) investment (asset / security / stock / bond) will have a greater standard deviation:
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We can look at each of the individual components (the grey dots) of the portfolio, determine their standard deviation and equate that to the combined total portfolio (red dot), to tell us what we might anticipate would be a likely scenario (% movement) for a significant negative (or positive) event.
This helps us to mitigate the downside risk to our portfolios: we know each of our clients exposure to risk and the potential fall in value should a major event occur. Last March was a significant event whereby the S&P 500 (for example) moved about 3 standard deviations (approx. 35%) lower over a very short period of time. In contrast, our balanced and diversified 60% equity / 40% fixed income client portfolios slipped by about 8% (depending on the composition of the portfolio) and the 40% equity / 60% fixed income client portfolios slipped by about 4%.
That is, my friends, by design. The less the portfolio goes down following a significant sell-off, the quicker the recovery and the sooner it gets back to growth mode and onward towards the average annual returns necessary to build toward long-term goals.
The evaluation of these downside risks allows us to ensure that we can create a combined portfolio best suited to mitigate them. And as we always and transparently will offer up: historical returns are not a guarantee of future growth, but at High Rock we work darn hard (behind the scenes) to make sure that we get our clients the best possible risk adjusted returns. If your advisor cannot tell you what your risk profile is, they are not doing their job.