Retired Couple

Kevin and Susan both worked for the same multi-national pharmaceutical company for decades and had recently retired when we met. They were introduced to Patton Funds via a close friend who had been a client of Patton’s for about 10 years.

Both Kevin and Susan enjoyed and continue to enjoy retirement but were anxious about their investments. When they became clients of ours in early 2010, the financial crisis of 2008-2009 was still a vivid memory. It had nearly paralyzed them with fear.

The vast majority of their liquid investments had been accumulated in their former employer’s retirement plan. They had an existing relationship with an advisor at Merrill Lynch who recommended they rollover their retirement plan money into IRAs. This was good advice but that’s were the good advice stopped.

We did a custom analysis of their portfolio at the time and what we found was very disappointing. Because of their fear of investing following the financial crisis, their Merrill advisor had 60% of their portfolio in cash, another 25% in bonds, and just 15% in stocks.

Kevin, Susan, and I had extensive conversation about their financial circumstances. I learned that they had a fairly conservative lifestyle. Furthermore, they both would receive a pension from their former employer for the remainder of their lives. This pension income combined with social security meets all of their financial needs. This made it evident that their aversion to investment risk was not due to the impact of a financial loss but instead the psychological impact of their portfolio losing value. This often is the case.

The psychological fear that Kevin and Susan were feeling was real and entirely understandable. That said, 85% of a portfolio invested in cash and bonds is not a prudent investment decision for any investor with a 2-3 decade time horizon (especially knowing they had no financial need for the money).

Maximum Drawdown – this is one of many measures of risk. It measures the biggest % decline that occurred from any peak to trough over any length of time. For example, since 1972 the S&P 500 (a measure of U.S. stock performance) has had a Maximum Drawdown of -51%. This occurred from the peak in October 2007 through the trough in February 2009. The S&P 500 has had other similar drawdowns since 1972 (the bear market of 1973-1974, the 1987 crash, and the 2000-2002 bear market) but none worse than 2008.

A well-designed diversified portfolio should not decline as much a just the stock market during bear markets…that’s the purposes of diversification. One good way to gauge an investor’s risk tolerance is to consider the Maximum Drawdown they would be able to endure during a rough bear market. Then is it critical to build a portfolio accordingly.

As we continued our conversation about their risk tolerance, a statistic we discussed was maximum drawdown. This is a measure of the worst loss a portfolio would have experienced. After lengthy conversations, they decided that losing 20% of their portfolio value during a bear market like 2008-2009 would have been tolerable (a bear market that produced a 50%+ loss for stocks).

We designed a Super-Diversified Portfolio for Kevin and Susan that fit their risk tolerance. There is certainly no guarantee that it will decline no more than 20% during future bear markets but analysis of 45 years of historic data indicates that would have been the case over that period.

Kevin and Susan have now been clients for several years. They have recognized substantial gains in their portfolio. We regularly discuss their risk tolerance and given the gains, they decided to increase it. They felt more comfortable knowing that when we do have a bear market, that much of what they may lose would be gains which makes it easier for them the psychologically handle. We redesigned their portfolio to fit this higher risk tolerance.

Miserable bear markets like the financial crisis of 2008 can leave investors paralyzed. Unfortunately this can result in tremendous forgone profits that can dramatically reduce long-term accumulation of wealth. Like Kevin and Susan, all investors need to really figure out what their tolerance for risk is and make sure they have a portfolio that is designed accordingly.

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