In order to have an efficient market, buyers and sellers have two basic opposing motivations – one to sell at the highest possible price and the other to buy at the lowest possible price. This constant tug of opposites creates a competitive market. The stock and bond markets are great examples of this dynamic.

As investors, we are exposed to information daily that influences our opinions as to both the short- and long-term prospects for the investment markets.

Ultimately, this plays out by creating volatility in markets with a bias to either the upside or the downside. Many long-term investors choose to ignore the daily barrage of information and instead focus on their long-term financial goals.

While this is a sound approach, as an investor you should know three things about your investment portfolio:

1) The expected long-term return of your investment portfolio (net of fees)
2) The volatility characteristics you can expect while the investment dollars are in the market, i.e. the magnitude of the ups and downs
3) The maximum “drawdown” potential of your portfolio. In other words, in a down market, what loss percentage might you experience

Long-Term Return Expectation

All portfolios can be analyzed to determine what the expected return is based on what type of assets are in the portfolio. Stocks, bonds, real estate, etc., all have long-term return characteristics and historical returns that can be mathematically calculated to arrive at a combined expected portfolio return. The return of your individual portfolio, in my opinion, should be in alignment with attaining your specific financial goals.

Retirement income, for example, is a common goal. Do you need a 5 percent, 6 percent or 7 percent average return over the long haul to achieve your goals? You should know that num-
ber. Once you know that number, you can compare it to your investment portfolio and make any course corrections that are necessary.

The numbers could surprise you. You might have a portfolio that has return characteristics that are much greater than what’s necessary. You’re then in a position to make a mindful decision
whether to keep the portfolio as is or make a change that aligns the expected return with your financial goals.

Volatility Characteristics

I call this one the “sleep quotient.” What amount of volatility can you live with and what amount will keep you up at night? Understanding what amount of volatility your investment portfolio may experience is key to living a life that isn’t full of surprises.

There are many mathematical standards and tools for determining portfolio volatility. One common calculation is called Standard Deviation. This tells you how much return, for both the up and downside, you can statistically expect in any given year. Volatility is another way of saying, “How much risk is in my portfolio?” It is well known by seasoned investors that in order to achieve a higher return you must accept a higher level of risk and, therefore, higher potential volatility.

Potential Drawdown

In my opinion, this is the one portfolio characteristic people are unaware of. Perhaps it’s because the investment community would rather not share this number with you for fear that you wouldn’t invest in the first place.

That said, you must understand the worst-case scenario and have peace of mind that your financial goals will not be in jeopardy should that scenario play out.

Potential drawdown or “loss” is mathematically calculated and is expressed by way of a percentage. Once you see the number and can be comfortable with that number, then the
portfolio is probably a good fit. If the number sends chills down your spine and you begin to hyperventilate, then perhaps you should remove some of the risk thereby reducing the potential
drawdown amount.

Take Aways

First, let’s try and learn from the past. In 2008, many investors that were close to retirement age were “asleep at the wheel” when it came to their portfolios and they were completely caught off guard by the volatility and drawdown they experienced. They were blind-sided and shocked at the consequences of the downturn. Many had to work more years then they’d planned to. That’s a hard pill to swallow.

One of the lessons learned in 2008 is that investors should be much more aware of the characteristics of their investment portfolio.

While we can certainly point fingers at many guilty parties for what happened in 2008, one of the lessons learned is that investors should be much more aware of the investment portfolio characteristics their advisors have put them in, or if you are a DIY person, then you need to do the math yourself.

Currently, the markets continue to climb to new highs. While the market climb may be supported by macro-economic data, investors are becoming increasingly wary and may have a feeling of “doom and gloom.” When is the next recession going to come? How deep will it be? What is the impact on my business or my employment?

In addition to these questions, you should also be asking about the potential impact on your retirement savings and other buckets of investment dollars. Knowledge is power, and it also helps you to sleep better at night!

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