I fear that one day when I wake up a meteor will hit the earth and I will have to scramble for cover, forage for food, and alter everything in my life. Is this a possibility? Yes, of course it is. But is this a probability? Should my actions be based on my fear or on what I believe to be probable? My contention is a realistic assessment of risks is important so as to not overstate the potential negative consequences associated with my fear coming true.
What does this have to do with a portfolio strategy?
Many investors focus on their fears. For this reason, they do not take action when probability suggests that a specified course of action be taken. This is certainly understandable given the Black Swan events that have occurred over the last 20 years. I mean really, could you ever have imagined a portfolio strategy of General Motors, Fannie Mae, Bank of America, and a host of other cratered assets would ever be so disastrous? Black Swan events are more and more prevalent, and therefore one needs to factor these downside risks into a portfolio strategy.
However, it is unreasonable to focus merely on disaster and not seek to capitalize on possible returns. We default to a more conservative strategy. But understand that this does not mean we adopt a bunker mentality where we do not take measured risks in portfolio strategies; offense and offensive is important in both sports and investing.
An investor's response to risk versus return is often binary. Said another way, a strategy is either 100% risk focused or 100%anti-risk. Instead, a more measured and balanced approach based on probabilities is the best strategy for most investors. This perspective will not yield home runs. But most investors are looking to capture results that help them move toward their financial goals while minimizing risk to the greatest extent possible. Home runs are net needed.
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I'm always amazed at how headlines or commentary from strategists focus absolutely on how the sky might fall. The market might correct 50%, Cyprus might result in the collapse of Europe, the Federal Reserve printing money may crumble and destroy American society, etc, etc. Are these issues to be dismissed? No - these issues pose real risks to investment strategy and economic growth. But this is not to say that disaster is certainly right around the corner. Risk mitigation is the appropriate response to these headlines.
You probably know investors that have been sitting in cash for years waiting until the world calms down. The world is never going to calm down. There will always be a new set of disasters right around the corner. Last week it was Cyprus, today it is Korea, tomorrow will be some other country in Europe, then it will be inflation, perhaps China will slow down even further, perhaps more political unrest in the Middle East; the list of possibilities is endless.
The key is to focus on constructing a portfolio that factors possible risks into your investment strategy and then invest to try to reduce the risk exposure while also seeking returns. Don't be binary. You'll drive yourself crazy reacting to the news pulse. Be thoughtful in your strategy and execute your plan. And be balanced; fear and optimism are just fine in measured doses.
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Michael Yoshikami, Ph.D., CFP, is CEO, Founder and Chairman of the DWM Investment Committee at Destination Wealth Management. Michael is a CNBC Contributor and appears regularly on the network. DWM is a San Francisco Bay Area-based independent money management firm that provides fee-based wealth management services to institutions and individuals around the world. Michael was named by Barron's as one of the Top 100 Independent Financial Advisors for 2009, 2010, 2011 and 2012.