Monthly Outlook: May 2024

Markets were a little soft in April, but the overall trend remains up, up, up! It’s been a good run since the recent lows in October 2023 and we’ve been “all in” to capture the growth that markets are giving us. Our strategy is to ride the uptrends for as long as they last. We never use “stop profit” orders, only “stop loss” orders. We’re watching all markets closely and will stay fully invested in each one as long as it is moving higher.

We can use this growth mode and quiet period to share some thoughts on an important topic. Today, we’d like to discuss risk tolerance, what it means, what it doesn’t mean, and how to make your portfolios truly reflect your own risk tolerance. If it’s smart to shop for umbrellas on sunny days, maybe it’s not a bad idea to contemplate risk during uptrending markets.

Risk Tolerance. What’s That? 

Clients of financial advisors are asked to complete a questionnaire that asks about your objectives, liquidity, taxes, time frame, and other factors. Then comes the big question, “what is your risk tolerance?” Many investors don’t know how to answer, and advisors don’t explain risk very well. In the financial industry, risk is synonymous with volatility. And volatility is measured by standard deviation. But who thinks in terms of standard deviation, right?

Let’s use a popular growth fund, the Vanguard growth fund (VASGX), as an example. It has 80% global stocks and 20% bonds, so it’s representative of a lot of investors’ portfolios. In round numbers, it’s had a 7.6% average annualized return over the last 15 years. And according to Morningstar research, it’s also had a 14% standard deviation. So, 65% of the time (which is 1 standard deviation), the fund has had annual returns between -6% and +21% (7.6% +/-14%). Most clients would reluctantly say that’s within their risk tolerance.

What if we look at 2 standard deviations? Then this Vanguard fund has had, 95% of the time, annual returns between -20% and 35%. That 20% loss potential will get a few investors’ attention. Some might say this still fits their risk tolerance, but a few would say it’s too much. It’s the same Vanguard fund, mind you, just presented differently.

Lastly, let’s discuss a different metric of risk called “drawdown.” This is the decline from a peak to a trough. It’s a better measure of “the ride” and not just year-end returns. For example, let’s say this Vanguard fund went up 15% in Q1, then dropped 25% during Q2 and Q3, but rallied 15% in Q4. It would have had an annual return of -1%. But it had a scary 25% drawdown along the way. If your $1m portfolio went to $750k, how would you feel?

Remember, all of these risk metrics are for the exact same Vanguard fund. As they say, “lies, dirty lies, and statistics.” What if you were only told the first metric (7.6%/yr. with a standard deviation of +/-14%) and had that expectation in your mind? When the 25% drawdown came along, would you feel unprepared for that? Would you have invested in this fund if you knew? This Vanguard fund has actually had nine drawdowns >10% over the last 25 years, ranging from -12% to -53%. Would this fund meet your risk tolerance, considering return, volatility, and drawdowns?

How to Manage Drawdown Risk

While the financial industry defines risk as volatility, most investors think of risk as the chance of losing money. For that reason, drawdown risk is a much better way to assess whether a portfolio mix is right for you. Ask!

There are two ways to manage drawdown risk: change your mix or change your strategy. If you are going to follow a buy & hold strategy and you want to reduce drawdown risk, you’ll have to change your mix by reducing your exposure to volatile stocks and increasing your exposure to less volatile bonds. But your expected return will go way down, too.

Alternatively, if you’re willing to change your strategy to actively manage your mix, you could use trend-following rules to keep you fully invested in uptrending markets and under-invested in downtrending markets within your portfolio. It takes discipline and consistency, but you should get better upside with a lot less drawdown risk. Limiting drawdowns allows you to sleep at night and stay the course. This is our iFolios strategy.