Do you know how much you should have in equites? Maybe it is time for you to complete an equity target questionnaire.
Written by Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.
It is quite common to find the collective behavior of people participating in the purchase or sale of an investment to push its price far from its fair value.
How you think and feel concerning such an investment influences your judgement. Your judgement in turn impacts your decision on whether to buy, sell or hold such an investment. And where an emotional decision is made or one based on poor logic, this can result in creating permanent losses.
A low tolerance for risk heightens the need to take action which, more often than not, pushes a decision to take a sell action on an investment that has just become better valued (assuming its long term ability to generate profits has not been materially impacted).
So let’s have some fun and look at one of several questions commonly found in a risk tolerance questionnaire:
QUESTION: Historically, markets have experienced periods of substantial short-term price swings (volatility) as well as prolonged down markets. Suppose you owned a well-diversified portfolio and that the stock market fell in the first year by 20%. And then in the second year the stock market fell by another 20%. The stock component of your portfolio has fallen in line with that of the market. Assuming you still have 10 years until you begin withdrawals, what would be your course of action?
(A) I would change my portfolio to one that is more conservative (less stocks and stock funds).
(B) I would not change my portfolio.
(C) I would not change my portfolio but wait until the stock market improves before adding to equities.
(D) I would ‘top-up’ my equities to my equity target.
(E) I would increase equities beyond my equity target.
In the scenario above, one’s portfolio has fallen ‘in-line’ with the market, so the idea of your having poor quality investments is not an issue. With the ten year time horizon before having to make portfolio withdrawals, this historically is long enough period where most stock market declines would have recovered.
If you are the kind of person that would have answered “A”, you would likely be making losses permanent. This would tell me that you have a very low risk tolerance and you’re not the kind of person that should be investing in the stock market without some education.
If you are the kind of person who would have answered “B”, it suggests to me that you could use some education on stock market historical volatility to appreciate how many times that the market has fallen by 20% and what the historical successive returns have been. Where the market was not excessively over-valued before such a fall, the subsequent future historical returns have been exceedingly good.
If you are the kind of person that would have answered “C”, it suggests that you might recognize the opportunity, but feel you have the skill to successively time the market. The reality is that most professional investors are not able to consistently time the market. If they could, there would be many market timing funds to invest in (and there are very few of those in existence). The problem with waiting is how much of a rise are you willing to forgo before adding. Also, the market can snap back up very quickly and the opportunity to add at bargain prices would be lost.
If you are the kind of person to answer “D”, that suggests to me a few things. One, that you have an equity target which most investors don’t have. Two, that you have an idea of how much to add to equities without exposing your portfolio to a level of volatility beyond what you are comfortable with. Three, you might be a conservative investor if you are not willing to take advantage of a relatively rare market event like this.
If you are the kind of person to have answered “E”, then you might be a sophisticated or experienced investor.
I hope that you have found this insightful. If you would like a second opinion of how much equities makes sense for you, you are welcome to complete my equity target questionnaire: http://www.lycosasset.com/Equity%20Target%20Questionnaire.pdf
If you’ve never completed an equity target questionnaire, maybe it’s time to change to a new advisor.