The Lowry Letter®

Week of 5/11/2022

We’re going to pause our normal format and speak about recent market volatility. An important concept is “risk premium.” Formally, it is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. In simpler terms, it is what you expect to be paid for taking on investment risk.

Risk and return have a positive relationship. Higher expected return requires higher investment risk. This is risk premium, and sometimes it can be a little scary.

One of the reasons we discuss risk tolerance is to understand what is appropriate for each of you. For the most part, those assessments hold up very well over time. Occasionally, changes in your circumstances or goals lead to change in risk tolerance, and adjustments are appropriate.

At least as important as risk tolerance is risk capacity. It is a measure of how much risk you can afford, or sometimes must take, to reach your goals. These two concepts work together. Longer-term goals, like retirement for younger clients, dictate higher risk capacity. So, we accept more risk, both because we CAN (length of time) and because we should (money needs to grow to match/beat inflation).

We adjust the amount of expected risk and return based on your situation (your tolerance and capacity).

Every investor will experience challenging periods where we must pay that risk premium. So far, 2022 is one of those times (especially the last month). During declines, we regularly review our investment models to assess their performance relative to appropriate benchmarks. On an individual level, we ask whether some material change in tolerance or capacity has occurred. Aside from those instances, maintaining a consistent and appropriate investment strategy is the best approach. Reinforcing this point, the attached chart from JPMorgan shows how the duration of investment has affected returns across different assets over time.

We don’t think timing the markets with drastic portfolio changes is appropriate for our clients or our practice. The speed of market movement, such as in the last few weeks, shows how quickly investor sentiment can shift. Making a sweeping change at the wrong time can severely limit the benefits of long-term investing. In other words, the risk premium must be paid, and patience is a critical investment skill.

In conclusion, we like this quote from author James Clear:

"The most important battles must be fought anew each day.

Exercising today does not render tomorrow's workout unnecessary.

Supporting your spouse today does not mean you can mail it in tomorrow.

Learn to love the endless nature of things and life gets easier."

This is true for investors as well. Dollar-cost average, collect and reinvest dividends, diversify - all examples of small battles that lead to long-term investment success.

As always, we are happy to discuss how your portfolio is serving your specific situation.

Here are some helpful articles for anyone who wants to dig a little deeper into this topic:

Brad McMillan on the recent declines and correlation to interest rates.
JPMorgan’s David Kelly on the potential for an “extended soft landing.”
Ben Carlson on “How Long Do Bear Markets Last?”

Investments are subject to risk, including the loss of principal. Because investment return and principal fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Diversification does not assure a profit or protect against a loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved. Past performance is no guarantee of future results.