As we find ourselves in the throes of winter, I’m already imagining sunny days (with no rain) and what I’m going to be planting this year in my garden. After a terrible crop last year, my mind is finding a way to escape the doldrums that we are currently living through by imagining bountiful yields of cucumbers, which I will turn into pickles. Besides the cold nights and dreadful weather we have illnesses to deal with as well. The flu virus claims many thousands of lives each year, and if that wasn’t enough to worry about, the coronavirus, or Covid-19 has made headlines recently as it has become worse than the SARS outbreak in 2003. While scientists and governments are still trying to get a grip on the potential impact of the virus, markets have been largely discounting any lasting effect from the virus. They have continued to make new highs since the virus first emerged in late 2019. The chart below shows the performance of the markets during previous epidemics.
The interesting note to keep in mind is to understand that while these illnesses were making headlines, there was a myriad of other events in the backdrop that were driving market returns. Adding virus worries into the mix of what investors are typically worried about like presidential elections, recessions, geopolitical turmoil, oil prices, etc. adds to the uncertainty of markets. It will magnify the ups and downs that we experience as investors.
So with the unknown outcome of the Covid-19 ahead of us, is this something that should worry investors?
Investors that have a financial plan to lean on during uncertain times shouldn’t be worried about how this event could affect their portfolio. There will always be these types of events in the market that no one can predict. Sometimes they will be mild and have only short-term impacts that may last a few days or weeks, while others will take months or even years to play out. Investors with long time horizons shouldn’t let these events dictate how they invest in the market or let it influence when to buy or sell. Financial plans are developed taking these types of events into account. Matching how much risk you can afford to take while still achieving your financial goals (risk capacity) with how much risk you can sleep with at night (risk tolerance) will help investors deal with both the good and bad periods of market returns.
Recently at RK, we have invested in a risk analytics tool (Riskalyze) to help quantify just these types of events for our clients and their financial plans. We can model different scenarios to understand both the worst case and best case scenario if similar events like an interest rate shock, a bear market in stocks, or even if a pandemic were to occur in the markets. Not only does the software quantify the risk in our portfolios holdings, but it also features a dynamic questionnaire that will define actual risk tolerance. The risk tolerance or the “sleep at night” factor helps to identify the maximum amount of loss that a client can withstand before they would feel the need to do something drastic in their portfolios. Once risk tolerance is understood, then we can compare this to the risk capacity that we defined when building long-term financial plans for our clients. Uncovering significant discrepancies between risk capacity and risk tolerance can then be mitigated by adjusting financial plans or portfolio allocations accordingly.
Defining and understanding how risk capacity and risk tolerance work in tandem is paramount for clients in these uncertain times that we live. Uncertainty will always be present in life and markets, but having a tool to separate the possible from the probable and give reassurance that portfolios can withstand market downturns while keeping our clients at ease is what makes this tool so valuable. We look forward to introducing this technology to our clients in the coming months.