Almost every investor knows that there is risk involved in the investing process. Most non-professionals have not given it much thought though. The focus is typically on investment gain, for after all, that is the purpose of investment. This primary focus on gain has perpetuated the acceptance and practice of the buy-and-hold style. With this approach, individual risk is calibrated, but not managed, by using asset allocation techniques.
We like to draw an analogy for this approach with a person driving a car with the cruise control turned on, so the car travels at a constant speed. The accelerator can be set to slow (low risk) and the car will usually get to the destination, albeit slowly (low return). At the other end of the risk spectrum the speed may be set to 100 mph and the car will travel very fast (high return), but is likely to crash before it reaches its destination and result in a total loss.
Since these neither of these extremes are acceptable to most investors / drivers, they will set a moderate speed by adjusting their portfolio asset allocation. This approach works alright most of the time. When the car is driving on the highway the moderate speed is very comfortable, but what happens when the highway suddenly turns into a dirt road? All of a sudden the ride becomes very uncomfortable and very risky. Occasionally, the road ends by dropping off a cliff (as has occurred in 2008 with the economy and the markets) and the driver goes over the cliff in disbelief, asking themselves all the while how this could happen.
Doesn't it make sense to use the car's accelerator to speed up on the highway
and slow down when the road gets bumpy? Not only is the ride more comfortable, in
most cases attentive driving will get to the destination faster and result in
The cruise control approach, which is usually recommended by most advisors, calibrates risk, but does not manage it. The personal control alternative actively manages risk. Does it take more effort and attention to actively drive a car than to use cruise control? Yes. Is it safer? Also yes.
The saying goes, "It is not how much you earn that is important. It is how much you keep". At LFM&P we believe that, if the emphasis is placed on managing (not avoiding) risk, then gains will follow. If one primarily focuses on gains, the chances are that too much risk will be taken, resulting in a "crash" and the loss of much of the gain. Likewise, if a driver / investor falls asleep at the wheel and ignores their investments, as is often the case, particularly in 401(k) retirement accounts, they are inviting an unsatisfactory outcome.
Most financial advisors follow risk calibration techniques. Many may believe they are managing risk, but there are reasonably few who actively follow a risk management approach, especially among those who advise other than very large portfolios. This becomes even more true when the stock market rises in a long bull trend. This static allocation approach has gained even greater popularity with the recently greater acceptance of passive investing with index funds. We suspect that when the pendulum swings back, and the next protracted bear market occurs, active involvement on the part of both investors and advisors will gain renewed attention once again.
LFM&P's MarketAwareSM risk management approach is our core investment philosophy that we have followed since our inception, and we will continue to do so. We suggest that you take the time, and make the effort, to find an advisor that does not merely calibrate risk and put you on cruise control, but will actively manage your risk to provide a more comfortable ride.
As Robert Frost might have suggested, the choice is yours.
Two roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth.
Then took the other, as just as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same.
I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I --
I took the one less traveled by,
And that has made all the difference.
Excerpt from A Road Not Taken by Robert Frost