Market Overview

Budgeting the balance

No, that’s not a typo and no, we’re not having a stroke. While balancing your household budget is certainly of paramount importance, we expect you already know how to do it and that you ought to be doing it.

No, this column is about helping you determine the correct balance for your investment portfolio: How much should you budget in equities, how much in fixed-income securities and how much in other investment classes? What proportion of your exposure should be to the domestic economy, how much to other the economies of other developed nations and how much to emerging markets? Which industrial sectors have better prospects than others? Should you be focused on growth or value? Once you’ve examined all this, you can say something to the effect of “I want 70% of my portfolio in stocks, of which 50% is in the U.S. market, of which 25% are in pharmaceuticals, of which 75% should be in growth-oriented firms. Then 20% of my stocks should be in …”

In that way, you can begin to budget how you balance the assets you’ve invested. (See what we did there?) By the way, the above example was for illustration purposes only. Before you budget your balance, you should get input from a trained and accredited financial professional.

But here’s how you can start the conversation.

Allocation’s increasing importance

There has never been a time when we would’ve told you, “Don’t worry about rebalancing your portfolio. Everything’s fine. You’ve got plenty of time to think about that.”

Still, 2017 was that rare year when you didn’t have to be smart or even lucky to grow your nest egg. At least in the short term, forming an investment strategy was a simple, two-part process: 1) Put everything in stocks. 2) Go golfing.

Then 2018 hit.

Suddenly, share prices are running hot-and-cold in a way we haven’t seen since 2011. Once again, we need to think before we invest.

Should you get out of the stock market entirely? The answer will differ for every investor, based on time horizon, your financial education, and largely your experience, meaning how you have previously invested and responded to changes in the market landscape. Still, for most of us, the answer will be “no.” What we need to be cognizant of, though, is a bias toward loss aversion – which we discussed here recently. Many if not most if not all of us have lost some money in equities over the past few weeks. Some will be tempted to dump stocks in order to avoid any further losses, while others won’t consider the losses “real” until they sell shares for less than they paid for them and thus will hold onto assets “until they turn around.” Both of these are emotional rather than rational responses.

We can’t say what that rational response ought to be, but it must be predicated on what we expect will happen next, not on what just happened. Maybe this is the time to move our money onto the sidelines until the equity markets pick a direction. Maybe this is the dip we’re supposed to buy on. The case can be made either way, and that’s why it’s imperative to come up with a portfolio mix and investment strategy that you can stick with.

What’s your risk appetite?

That’s not to say your emotions are wrong. Only you know what how much risk is too much, and that’s a highly personal decision.

You can start with some basic questions, some of which just scratch the surface of what is critical to an investment discipline, especially your understanding of the risks involved in investing:

• What is my goal for the money I am considering investing?
• What is my time horizon?
• Do I have the right amount of emergency reserves?
• Am more focused on growth or minimizing potential for losses?
• Do I understand the fundamental concept of what a stock share is?
• Do I understand what a bond is?
• As time goes on, how did I respond—both emotionally and in action—to periods when my investments went down?

There are a bunch of different ways of measuring investment risks: systematic risk, standard deviation, concentration, liquidity risk, credit risk, interest rate risk or duration, default risk – the list goes on and on.

So it is imperative that you to take an inventory of your financial circumstances, your goals, your understanding, your feelings and – most certainly – your discipline, in order to tailor your portfolio to maximize your expected returns given your willingness to expose yourself to the catalog of risks involved in investing. If you want to grow your net worth aggressively, your results will differ dramatically from another investor who wants to avoid any losses, which in turn will differ from another who just wants to avoid a nightmare scenario.

But your appetite for risk is probably not strictly defined by any of those three hypotheticals. Only you and your financial advisor can accurately define your individual risk profile. And, only once that’s been established can you budget your risk and rebalance your portfolio in order to invest with confidence.