There Is No Right Answer
Today I was thinking about the questions you must answer when you open a brokerage account.
I’m not sure how my mind drifted into the topic. The last thing I remember was reading an article about the differences between behavioral economics and traditional economics.
Then I thought about how difficult it is to describe a “risk profile”. How would I describe my risk profile if I had to?
Aaah – that’s it ! Behavioral economics. How we make decisions about our financial lives and well being.
If asked on a new account form to select the box that best described my investment goals and my risk tolerance, what would I choose? Here are examples:
- Capital Preservation
- Income
- Growth
- Moderately Aggressive
- Aggressive Growth
- Speculation
What bothers me about the investment world is the assumption that everyone is going to know what each category represents.
It isn’t intuitive so I am going to talk about each one.
The investment goals listed above are in order of investment risk. Capital Preservation is Low Risk and Speculation is High Risk.
There is no category that is No Risk.
These are common choices however picking one category for your overall profile would be a mistake.
As human beings with human behavior, each category plays a role in developing an investment goal and a risk tolerance that best fits YOU.
Thus spoke Behavioral Economics, yeah! *
In my view, the answer must be a blend.
Before we can blend, we need to understand what each category represents before investing.
Capital Preservation : Do I want to keep the money I have? Preserve my capital? Of course I do. Do I want to limit losses in my portfolio? Of course I do.
What is not obvious is that capital preservation is a strategy that means your investment portfolio should be invested in short maturity Treasury bills or Certificates of Deposit. There is no opportunity for your money to grow. Basically, capital preservation is as low risk as you can go.
If I factor in inflation over time I will lose money. I may not suffer the types of losses that could occur in the stock market but without any growth potential, inflation will devalue my capital. In a sense “Capital Preservation” is a bit of a paradox.
Income: Are you going to say NO to income? Income is derived from dividends on stocks and interest on bonds. An income strategy is more common for people who are close to retirement. Without income from an employer, retirees need to replace wage income with income from savings.
An income strategy becomes a slippery slope for replacing wages. What if your savings cannot generate enough income? And, using only an income strategy you may forego capital appreciation in either stocks or bonds.
Growth: This is where things start to get interesting. Growth means capital appreciation which means the price of stocks goes up (or down). Growth stocks typically do not pay dividends but hey who cares? Everyone wants the next Amazon or Apple, stocks that go up up up. That does not mean prices will go up every year. But over 10 years or 20 years? The risk is that some companies don’t grow at all or very slowly.
The growth category is the starting point for this question: “How much can you stand to lose?”
If you have $10,000.00 in savings, how will you handle losing 10%?
The twist is that losing does not mean you will never gain it back, but it might take some time.
You see your $10,000.00 shrink to $9,000.00. Are you still breathing? Still standing? If so then I would say you are okay in growth stocks.
Moderately Aggressive: Risk versus reward. If I told you that you might lose 20% or 30% but over time your returns will be much higher – can you stand the loss believing in the long run it will be “worth it”.
If seeing your portfolio value drop from $10,000.00 to $8,000.00 triggers an “I’m out of here, sell everything” moderately aggressive may not be for you.
Aggressive Growth : Grrrrrrr!!!! Yes I can stand the pain. Yes I am in it for the long term. Yes my portfolio can drop 50% without raising my blood pressure. Yes bring it on. We get the point. You want aggressive growth stocks.
But do you want your entire portfolio invested in aggressive growth? Probably not.
Speculation: Have I told you the story of TNT Tony? TNT Tony scammed the living daylights out of people gullible enough to believe that investing in the Iraqi currency known as the dinar, could return, oh, at least 1000%. Or was it 10,000%?
The Gullibles hand over US dollars in exchange for Iraqi dinar. When the dinar miraculously is revalued (up of course) the Gullibles sell their dinar for millions of dollars becoming rich overnight.
Is the Iraqi Dinar Investment a Wise Investment? (investopedia.com)
Speculation means losing your money with no recourse. Kind of like buying lottery tickets.
There are legitimate speculative investments, but most people do not have the means to withstand a significant loss, regardless of the “upside” potential.
How you structure your investment portfolio will require you to judge your reactions to different scenarios, especially when it comes to withstanding losses.
My portfolio is currently a combination of cash (too much at the moment), income though both stocks and bonds, and growth stocks.
I skip the moderate growth and aggressive growth categories, but I am currently looking for a small investment in commodities. Commodities are another asset class and subject to more price volatility than stocks or bonds.
As you can see, there is no way for me to pick ONE category to describe my investment objectives and risk tolerance.
I guess the right answer is: “Check All the Boxes that Apply to You”.
*an allusion to “Thus Spoke Zarathustra” by Friedrich Nietzsche. A work of philosophical fiction.
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