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News and Information From 
Milestone Financial Advisors, LLC
Volume 4 Issue 3   March 2011
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Risk Capacity vs. Risk Tolerance
Understanding Different Types
of Investment Risk
risk

Last month I published a short blog article concerning the difference between "risk" and "volatility."  On the heels of a fairly volatile month in the markets - accentuated by political instability abroad and spiking oil prices - and looking ahead to the battle over the budget here at home, a more detailed exploration is warranted.   

 

Because all investments involve some amount of risk, it is important to consider how we think about risk in our portfolios.  In general terms, most would agree that the two biggest risks investors face are inflation and market volatility.  Since it would be extremely difficult to avoid both risks at the same time, an investor's time horizon becomes the determining factor:  to the investor with a short horizon, portfolio stability is the most important objective, as market loss would be more damaging than inflation.  To the younger investor, loss of purchasing power is a much more serious consideration, therefore investments focused on long term growth should be the primary focus. 

 

Digging a little deeper, there's also a degree of difference between risk capacity - the factual ability to withstand downside risk, and risk tolerance - the psychological willingness to withstand it.  This is, admittedly, a fine distinction, but it is a critical one in planning the allocation of your investments.  The strategy which your portfolio is built around needs to conform to your capacity to tolerate risk ("I am comfortable having 90% of my investments in stocks"), but it also needs to have a pattern of returns that will not lead you to abandon it because your willingness to tolerate risk is insufficient.  ("The market is heading for a correction and I don't want 90% stocks any more.)1

 

This is particularly true during extreme market periods.  It does no good to know that a 90% stock allocation will most likely outperform a 70% stock allocation over 40 years if you are likely to abandon the portfolio during a volatile market environment.  

 

You'll forgive me the digression into the arcane.  Suffice to say that these considerations, esoteric though they may be, assume a central role in the construction of your portfolio, from the creation of your Investment Policy Statement to the eventual allocation of your assets.   

 

To the extent that you have a sense of peace (or at least acceptance) in the complexion of your portfolio, we can attribute this to a healthy understanding of the types of risk we face as investors, and how this understanding is eventually incorporated into the methodologies currently being used in the maintenance of your accounts. 

 

 

1 Attributable to Robert Gibson, from Asset Allocation: Balancing Financial Risk, McGraw-Hill, 3rd edition, August 2000. 

 

Seeking the Perfect Wave
Timing the Market Timers
New York Times columnist JefMarket timingf Sommer, acknowledging recently that he found himself in a "buoyant mood" due to the steady rise in stock prices, sought out someone with a gloomier assessment of the financial markets to provide a counterweight to what he feared could be excessive optimism.

He turned to Robert Prechter, a veteran market analyst who has published The Elliott Wave Theorist in Gainesville, Georgia, since 1979.  As Mr. Sommer reported last week in the Times, Mr. Prechter's investment outlook is "as bleak as an ice storm."  Based on his interpretation of cyclical wave patterns that he discerns in both financial markets and "social moods," Mr. Prechter believes the current rally is only a minor upswing within a much larger, longer, and punishing downtrend that will "lead the unwary to ruin."

Market forecasters are often accused of double-talk, couching their predictions in such convoluted language that they can later claim success regardless of the outcome.  At least there is little doubt where Mr. Prechter stands.  He sees disaster ahead and has been saying so for quite a long time.

In an earlier interview with the New York Times in July 2010, Mr. Prechter suggested the US stock market had entered a decline of "staggering proportions" that would likely see the Dow Jones Industrial Average - 9686 at the time - fall well below 1000 over the next five or six years.  Although the Dow has surged over 27% since that time (as of February 18), Mr. Prechter is unperturbed and argues that the outlook is "much more dangerous today than it was last summer."

Perhaps Mr. Prechter will be proven right.  But if not, he appears to have ample reserves of both patience and conviction.  If his grim vision of deflation and depression sounds familiar, it should - he was making similar arguments in this book At the Crest of the Tidal Wave, first published in 1995.

Mr. Prechter has made some prescient market calls in the past, notably in the 1982-1987 bull market, but success since that time has proved more elusive.  If only we could determine when to follow the advice of a market soothsayer and when to ignore it, we could be exponentially wealthier.  But timing the market timers appears to be no easier than timing the market itself.


Thanks to Weston Wellington for the above commentary


 

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Ten Key Portfolio Considerations:
 
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Information contained in the above commentary does not constitute formal advice or recommendations by Aaron Winer, Milestone Financial Advisors LLC or it's affiliates.