What Your Financial Advisor Doesn't Do for You
There is a fancy new investing term out there... Risk Budgeting.
Have you ever had a financial professional ask you what your risk tolerance is? Are you a high risk investor, moderate risk or low risk investor? Once answered, you usually get an asset allocation based on standard models, usually spit out by a computer and BAM... There is your portfolio.
Everyone has their own threshold on how much risk they are really willing to take.? This isn't some pie in the sky concept. It is called risk budgeting.
So what is risk budgeting, aka risk allocation, and why do you need it? Budgeting for risk is a new concept. Traditional asset allocation tried to do this for you, but did not take each piece of the pie seperately. Now you can and should. You budget the rest of your life, you should budget for risk as well.. I think I can answer that for you.
Forget talking about the technical terms like alpha and beta that financial advisors use to sound smarter than you. Address what the real dollars mean to you and set the budget according to what you are willing to lose.; after all, that's what risk is all about - how much are you willing to lose for that extra dollar gain. Are you willing to lose $0.20 for a year or two to gain a dollar in the 3rd year? How about $0.10 or the other direction at $0.50?
Let's use an example. Say you decide you want to diversify better and add an agriculture mutual fund, ETF or the real commodity to your portfolio. Let's say you want to add this investment to 3% of your portfolio of $500,000, so you are investing $15,000 to agriculture.
So of that $15,000, how much are you willing to lose? All of it? If you lost all of it, your portfolio would be down 3%, not much in today's climate. So if you are willing to lose 3% and you really believe in agriculture right now, shouldn't you put more in knowing that it, for all intensive purposes, won't go to zero?
Let's say you are OK putting 5% in or $25,000. Now, you aren't comfortable losing all of that $25,000. Well, Watson, you found your risk budget for agriculture. If you are OK losing $15,000 but not $25,000, isn't your risk $10,000? And if your risk is $10,000 on $25,000, then you are willing to risk 40% on this piece of the pie. Knowing that this is a riskier, more volatile investment, 40% may make you a moderate investor.
Most people would assume losing 40% on a portion of their portfolio would make them a high risk investor, but if 40% of agriculture only equals 2% of the overall portfolio, I would completely disagree. You probably wouldn't say you are OK losing 40% on your stock or bond portion of your portfolio. Each piece of the pie has to be analyzed separately.
The next question is: What do you do when your agriculture investment falls by 40%? That is a personal decision that should be planned and strategized way ahead of time.. That is what a good asset allocation and good advisor will do for you, help you plan.
Wondering why? What happens when the stock market, or any investment for that matter falls by 40% like it did in 2008-2009? You get emotional and make emotional decisions and I personally don't do well with those types of decisions. If you have a plan ahead of time, you will never have to make a decision in the heat of the moment. The decision would be well thought out and would be executed accordingly.
You are probably thinking, this sounds great, but my advisor doesn't do this and I don't have time for this. It could take you all day to come up with your risk budget for each investment class.
You are in the majority on this one. Ask your advisor to put a plan together for you and if they decline, find another advisor. Better yet, get an advocate.
Leave it to someone who has already done the work for you.
In an economy where the stock market moves 5% in a day, have a plan for your risk budget and make sure your strategy will let you sleep at night.
For more than 20 years, Julia Lundstrom, CFP has been on the front lines of investing and financial planning for individuals and businesses. You can read more about her recommendations on asset allocation and risk budgeting by visiting http://refinedassetallocation.com or reading her blog at http://refinedassetallocation.com/blog.
Have you ever had a financial professional ask you what your risk tolerance is? Are you a high risk investor, moderate risk or low risk investor? Once answered, you usually get an asset allocation based on standard models, usually spit out by a computer and BAM... There is your portfolio.
Everyone has their own threshold on how much risk they are really willing to take.? This isn't some pie in the sky concept. It is called risk budgeting.
So what is risk budgeting, aka risk allocation, and why do you need it? Budgeting for risk is a new concept. Traditional asset allocation tried to do this for you, but did not take each piece of the pie seperately. Now you can and should. You budget the rest of your life, you should budget for risk as well.. I think I can answer that for you.
Forget talking about the technical terms like alpha and beta that financial advisors use to sound smarter than you. Address what the real dollars mean to you and set the budget according to what you are willing to lose.; after all, that's what risk is all about - how much are you willing to lose for that extra dollar gain. Are you willing to lose $0.20 for a year or two to gain a dollar in the 3rd year? How about $0.10 or the other direction at $0.50?
Let's use an example. Say you decide you want to diversify better and add an agriculture mutual fund, ETF or the real commodity to your portfolio. Let's say you want to add this investment to 3% of your portfolio of $500,000, so you are investing $15,000 to agriculture.
So of that $15,000, how much are you willing to lose? All of it? If you lost all of it, your portfolio would be down 3%, not much in today's climate. So if you are willing to lose 3% and you really believe in agriculture right now, shouldn't you put more in knowing that it, for all intensive purposes, won't go to zero?
Let's say you are OK putting 5% in or $25,000. Now, you aren't comfortable losing all of that $25,000. Well, Watson, you found your risk budget for agriculture. If you are OK losing $15,000 but not $25,000, isn't your risk $10,000? And if your risk is $10,000 on $25,000, then you are willing to risk 40% on this piece of the pie. Knowing that this is a riskier, more volatile investment, 40% may make you a moderate investor.
Most people would assume losing 40% on a portion of their portfolio would make them a high risk investor, but if 40% of agriculture only equals 2% of the overall portfolio, I would completely disagree. You probably wouldn't say you are OK losing 40% on your stock or bond portion of your portfolio. Each piece of the pie has to be analyzed separately.
The next question is: What do you do when your agriculture investment falls by 40%? That is a personal decision that should be planned and strategized way ahead of time.. That is what a good asset allocation and good advisor will do for you, help you plan.
Wondering why? What happens when the stock market, or any investment for that matter falls by 40% like it did in 2008-2009? You get emotional and make emotional decisions and I personally don't do well with those types of decisions. If you have a plan ahead of time, you will never have to make a decision in the heat of the moment. The decision would be well thought out and would be executed accordingly.
You are probably thinking, this sounds great, but my advisor doesn't do this and I don't have time for this. It could take you all day to come up with your risk budget for each investment class.
You are in the majority on this one. Ask your advisor to put a plan together for you and if they decline, find another advisor. Better yet, get an advocate.
Leave it to someone who has already done the work for you.
In an economy where the stock market moves 5% in a day, have a plan for your risk budget and make sure your strategy will let you sleep at night.
For more than 20 years, Julia Lundstrom, CFP has been on the front lines of investing and financial planning for individuals and businesses. You can read more about her recommendations on asset allocation and risk budgeting by visiting http://refinedassetallocation.com or reading her blog at http://refinedassetallocation.com/blog.
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