In my recent commentary, I showed that if an investor couldn’t handle a 12% drawdown in stocks then they really have no business investing heavily in stocks at all since 12% is quite unremarkable and common for stocks. That was essentially scratching the surface of what I mean by emotional capacity for risk.
I also mentioned that we don’t often know our true risk tolerance until it is tested, which is why I also make sure to identify clients’ financial capacity for risk using stress tests within their financial projections.
So, I wanted to briefly provide a real-world example of this exercise.
Case Study
A couple has recently hired me who has done a tremendous job saving for retirement, which is now ideally just three years off.
Currently, their portfolio holds about 80% in stocks, which is quite aggressive but has served them well to this point.
When I run the financial projections using their current investment strategy, albeit with conservative return and spending assumptions, they have a 90% probability of success, which is fantastic.
Put another way, there is just a 10% chance they will have to make some adjustment in the future even if they were to change nothing. Adjustments often take the form reduced spending and/or extending working years (for folks not yet retired).
My job is to optimize their financial health and maximize their probability of success / minimize the risk of failing to meet their financial objectives, or minimize the risk of having to make undesirable adjustments.
When I ran a bear market stress test assuming about a 30% loss in their portfolio as a result of a bear market in the near future with the current investment strategy, their probability dropped to 61% (see below). Realistically, the next bear market will likely produce greater than 30% losses for traditional 80% stock portfolios.
In other words, a routine bear market potentially jeopardizes the financial goals they’ve worked so hard and sacrificed for throughout their careers. Such an event with the current allocation might necessitate reduced spending and/or delayed retirement, both of which we want to avoid if we can.
Oftentimes, small adjustments now can vastly improve probabilities of achieving financial goals across a variety of scenarios.
In this particular case, I ran a second scenario. Because the probabilities already looked so good and they are already aggressive savers, the only change I made was to reduce their allocation to stocks to around 40% from 80% during this critical next few years to explore the impact on their financial independence.
The general probability of success actually increased slightly to 91% from 90% even with lower short-term return assumptions.
That might not seem like a huge change, but what’s more important is that when we run the bear market stress test on the second scenario with the more conservative investment strategy, the probability is a much greater 87% versus 61% in the first scenario (see below)!
That’s a tremendous difference. That simple change obviously makes them far more resilient to adverse stock market conditions. Yes, it could mean they give up some returns on the upside, but it’s a small price to pay for greater security, financial freedom, and lower stress / anxiety about what the market might be doing day-to-day, month-to-month, year-to-year. The goal is not to maximize returns but maximize the ability to maintain their financial independence across a variety of market, economic and personal circumstances.
Additionally, the adjustment to investment strategy proposed also makes irrational, emotional decisions (like selling stocks at the worst time) less likely thereby increasing the likelihood that we remain disciplined and stick to the strategy even through a bear market, which vastly improves long-term outcomes.
As we continue to update these projections every year, and monitor market valuations, it’s likely we’ll get more aggressive again at some point down the road when a bear market has a far smaller impact on their financial independence.
Obviously, these aren’t perfect projections because they rely on imperfect, unknowable assumptions. And every bear market is different.
But the idea is to identify potential holes / weaknesses then use that information to make adjustments that increase our resilience to a variety of adverse events that are outside our control.
My primary goal with clients is to maximize their probability of maintaining their lifestyle for the rest of their lives across a variety of inflation, market, and personal circumstances.
