Investment Risk Management: 2X vs. ½

Investments should be made to enable you to accomplish specific goals.

You may not have specific plans for what to do with your accumulated investments, but you would have the general purpose to increase the value of your portfolio or attain a certain amount of annual cash flow at a given point from the interest and dividends. Whatever your goals, you should consider the risks and perform at a “simple” risk versus reward evaluation, as I explain here.

My general advice is to not invest in the stock market if you do not have at least a seven-year time horizon, and to be more conservative I suggest a ten-year horizon. That means if you think that there is a faint possibility that something might occur where you would have to sell some of the investments, then you should not invest that amount in the stock market.

To provide an example, if you are saving to acquire funds for a down payment for a house or to have funds for a child’s college costs, or to buy a boat, and these events will occur within the next seven or fewer years, you should not invest those funds in the stock market. The market fluctuates daily and over a prolonged period it self-corrects, but it could also go through an extended period of a downturn. If you need your funds during that period, you would be selling in a down market and possibly might not realize what you will need. The longer period will protect you from momentary downturns because the long-term trend has been upward. However, we just do not know when that will occur, and the longer term would provide a greater degree of protection.

We never know how things will work out, and it is possible that the downturn might occur just before the end of a ten-year period in the month before you need to make that withdrawal. However, the portfolio should have increased during the previous years and the losses will be out of your gains. Even so, this means you must oversee how your investments are faring. You should have a plan, and while you should stick to it as much as possible, you should not place your investments on autopilot. You would also need more careful oversight in the periods closing in on your targeted withdrawal date.

When I write about the stock market I am referring to a well-diversified portfolio. I have my idea of a well-diversified portfolio, but you should meet with your financial advisor and determine how your portfolio would be “well-diversified.” Note that I do not include “rainy day” funds in any investment portfolio. You can read what I say about this at Rainy Day Funds – Withum.

Now, in managing your risk I have a simple method. Answer these two questions:

Let me explain this. If your portfolio doubles in value, will it cause you to change anything you are doing, or provide you with funds to buy something you’ve been holding off on? If it didn’t, then the doubling would not have created any tangible benefit. You will certainly feel good about it, but you won’t be using the added funds to benefit you presently.

On the other hand, if you lose half of your funds, would it cause you to curtail some of your spending? If it does, then you will be hurt. In these two scenarios it appears the losses will hurt you more than the gains will benefit you. So, do not make the investment!

Weigh the benefits of having 2 times your money versus ½ of your money. And then make your decision.