Why Mike’s Conservative Investment Strategy Can Be Very Risky
A new client, whom I’ll call “Mike,” recently came to me with questions about his investments. In his mid-forties, Mike had always been wary of losing money in the stock market. Apparently, he would rather have avoided losing $1 than making $5. But Mike knew something was wrong, as the value of his portfolio had remained stagnant for almost 10 years.
He and I had a long talk. We identified several defects in his investment “strategy” that prevented him from growing his wealth.
Missing Opportunities by Avoiding the Market
Mike was always looking for confirmation of his bearish strategy. During bull markets, he felt that the bottom was about to drop out and that everyone would end up losing money. Mike did not see bear markets or market corrections as an opportunity to buy stocks at a bargain price. Instead, he thought that investors were throwing away their money on a losing proposition.
Yet, somehow Mike knew that he was missing out on some of the best years ever in the stock market. He couldn’t understand how investors he knew were increasing their wealth over time. In other words, Mike was blind to the opportunities to grow his capital by investing in different types of assets.
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High Concentration in Low-Return Investments
Mike invested 80% to 90% of his portfolio in fixed-income securities. He concentrated on short-term Treasury bills, money market accounts, and CDs. He cared so much about safety that he was willing to accept microscopic returns.
Mike’s occupation is in the food industry, and he solely concentrated his stock investments there. In some years, his assets did OK, but often, they failed to participate in the overall market gains.
Diversification wasn’t part of Mike’s vocabulary at the time. He thought his approach was “conservative” because he invested only in the industry that he knew best. He failed to realize that highly concentrated portfolios risk significant losses all at once.
The concept of diversification in investing refers to owning a wide variety of securities across several asset classes to defray risk. Diversified portfolios survive over the long term. You dilute risk when you spread your investments over many asset classes because some investment values rise while others fall.
It’s called hedging your bets. You invest in asset classes that mitigate the risk of losing everything all at once. The wider the range of assets, the more pronounced the effect.
It’s no longer good enough to mix your investments between stocks and bonds alone. There are many other asset classes, from real estate to collectibles to commodities, that are only weakly correlated, if at all.
By the way, Mike was certainly not alone in putting himself at financial risk by failing to diversify. A 2019 study by the UBC Sauder School of Business compared the performance of correlated stocks vs. stocks chosen entirely at random. Random won.
According to the study, “… less experienced investors are failing to diversify — and could be putting themselves at serious financial risk. The effect is so pronounced that many amateur investors would be better off choosing stocks at complete random.”
Another fascinating outcome of the study was that risk-averse investors were encouraged to make safer, diversified choices. Others were advised to simply “avoid risk” This paradox points to a confusion about risk by folks like Mike. He intended to avoid danger, but he accomplished just the opposite by investing in a narrow slice of highly correlated stocks.
Mike’s outlook concentrated on worst-case scenarios. The problem was that his investment style invited those scenarios by leaving his assets completely unbuffered. If the food industry had a bad year, so did Mike, even when the overall market did well.
In the best-case scenario, you can make money to improve your lifestyle and secure your retirement. You might also be able to recover from financial losses over time.
Not Keeping up with Inflation
For many years, Mike thought inflation was dead and didn’t worry about it. Inflation had indeed been tame for some time, but as always, it would and did return. But even during the low-inflation years, Mike’s portfolio failed to keep up. Recently, things have gotten worse, and it’s evident that his buying power is now lower than it was 10 years ago.
Mike thought you had to take “crazy” risks to beat inflation. By putting the vast bulk of his money into “safe” investments, he ensured the overall decline of his wealth. I was gratified to show him how a well-diversified portfolio consistently beat inflation with much less risk.
Other Common Mistakes
Mike’s basic fear of losses caused him to make a few other common mistakes. One was to sell his stocks after a bear market started. He had such faith in his food stocks that he wanted to hold them forever. But when prices slid, he usually sold his shares, often at a loss, only to repurchase them later at higher prices.
Buying high and selling low are sure ways to destroy your wealth. I generally advise clients to diversify their investments. Trying to time the market just locked in Mike’s losses.
Another mistake Mike made was his extremely narrow universe of assets. He was not familiar with how asset allocation could help him adjust his risk over time. The idea is to spread your money over many asset classes and slowly adjust those allocations over time. Through proper asset allocation, you can adapt your investments to provide the appropriate level of risk for your circumstances.
If you aren’t happy with your investment performance, you may be better off switching financial advisors. I invite you to contact me for an overall review of your strategy. You might find that, like Mike, your aversion to risk is, unfortunately, exposing you to a high amount of it.
Schedule a no-obligation conversation with me directly. Best case scenario, we verify that the strategies you are taking make sense. If they’re not, this simple conversation can be a game-changer!
