The financial fundamentals of risk evaluation are becoming more important than ever. This week, the S&P 500 reached a record level, surpassing the previous peak, which occurred on February 19th. After just a few months, the Index fully rebounded from a decline of 34%, which marks that fastest bear market recovery in history.
The S&P 500 Index is market-cap-weighted, meaning that the companies with the largest market capitalization make up more of the Index and have a greater impact on the performance of the overall Index. The top five companies – Apple, Microsoft, Amazon, Facebook, and Alphabet (or Google) – make up more than 20% of the Index and significantly impact the performance. For 2020, the S&P 500 Index is up 4.9%, whereas the S&P 500 Index on an equal-weighted basis is down almost as much. Moreover, the Russell 2000 Index, which is the leading domestic small-cap index, is also negative on a year-to-date basis at -5.1%.
This dispersion illustrates that the enthusiasm for the largest of the large-cap tech stocks is not widespread. The stock market is forward-looking, and expectations appear to vary considerably. When the market began to plummet in late February and into March, friends called to ask whether they should reduce or eliminate retirement plan contributions.
I recommended that they first consider their emergency reserve and overall liquidity. If the reserve and liquidity were in good shape, I explained that this was the wrong time to reduce retirement plan contributions. If anything, they should like about increasing those contributions. When markets decline, your retirement plan contributions go farther. Fear and worry are genuine, however, and some told me they decided to cut back but not eliminate their contributions.
Events in recent months illustrate why it is so vital for all us to understand risk and financial fundamentals. Risk is the variability, or volatility, of expected outcomes. The weather is a good illustration. A forecast gives an average or expected temperature for a city on a particular day of the year. In some regions, such as Southern California, there is less variability, or volatility, in temperature for a given day of the year. In other areas, such as Chicago, there is much more variability, or volatility, in temperature for a particular day of the year. Standard deviation is a measure of volatility that looks at how far an actual outcome might be from the average or expected outcome. The standard deviation in the weather for a particular day of the year is greater in Chicago than it is in Southern California.
Likewise, for investments, the higher the standard deviation of outcomes or returns, the greater the risk. Investors should be compensated for taking risks and will demand a higher return. In other words, as expected volatility rises, so should the anticipated return. If you maintain a long-term view, you can withstand this volatility. All else equal, staying invested, and not trying to time the market by moving in and out, will lead to better outcomes in the long run.
Not only should you think about the risk associated with your investments, but you should also analyze risks to your financial profile. This is an area people don’t often consider. If you don’t begin with an assessment of your risk profile, you cannot make sound decisions about the risks associated with your investments.
You need to be objective and consider how another person would view your financial situation. Be honest with yourself so you can identify areas where you might be able to make changes. Do you have a steady income? Do you have an emergency reserve? Do you have a lot of debt? Do you have adequate liquidity? This exercise is known as risk management.
In contrast to risk management, risk tolerance is about personal preferences, or how comfortable you are taking on risk. The volatility of returns for different investment choices varies. Just as you need to be objective about your financial profile, you need to be honest about your comfort level with varying degrees of volatility. As you consider if you want to be conservative, moderate, or aggressive with your investments, think about your time horizon. The longer your time horizon, the more risk you can assume.
If you want to learn more financial fundamentals and get started managing your financial life, see our collection of Educate Yourself About Investing posts.
