Am I taking enough risk in my portfolio? It’s a question we hear often when markets are doing well. Not so much when they aren’t. We believe the best strategy for you is the one that you’ll stick with! One of the challenges in providing financial advice is determining how much risk a client is willing to take. When building your risk profile, Falco Wealth considers three components of risk: how much risk you can take given your financial position; how much risk you must take given your goals; and how much risk you are willing to take given your preferences. A sound financial plan helps us to identify those first two components. We tend to weigh that third component most heavily, yet it’s the trickiest to decipher.
How do financial advisors measure your risk tolerance? Broadly speaking, financial advisors use a risk-profiling questionnaire to assign you a risk score. If you’ve worked with a financial advisor, you’ve likely taken one of these questionnaires. They’re typically 10 – 20 multiple-choice questions. The scores usually range from 0 to 100. The higher the score, the higher your risk tolerance. Some advisors rely solely on that risk score. They’re neat and regulator-friendly. But does that score tell enough of the story? Is there a way to confirm that the score truly reflects your risk tolerance? How else can we measure your risk tolerance? We think we can gather more information through simple conversations about risk.
Falco Wealth discusses a metric called historical maximum drawdown, in conjunction with your risk score, to identify an asset mix you’ll likely stick with to pursue your goals. Historical maximum drawdown is the largest decline an investment has experienced over a given period. In the finance industry, we call this the “peak to trough” experience of an investment strategy. Think about max drawdown this way: you’ve climbed a mountain to its peak, but before you’re able to take that selfie to prove you were there, a gust of wind knocks you back down the mountainside. Undeterred, you get back up and start climbing again, but before you reach the peak, you slide back down the mountainside even further than you did the first time. You repeat this process a few times before finally making it to the top again to snap that selfie. The maximum drawdown would measure the distance from the summit to the lowest point of your falls.
We often find that once a client’s account balance reaches a high, even if that high is far above your original investment, you become attached to that high point. Any dip from it feels like a loss. While it doesn’t measure the frequency of losses or the duration of recovery, we think that max drawdown is an effective tool for measuring your willingness to take risk. It considers the maximum amount of pain you may have to endure to stick with your investment strategy through inevitable ups and downs.
We use the graphic below from Dimensional to help clients visualize the historical range of outcomes across various stock-and-bond mixes. Interestingly, it doesn’t fully tell the max drawdown story because it only measures the maximum pain you’d experience in a calendar year. Drawdowns can occur over multiple calendar years and last for longer than twelve months. For example, in the graphic, the worst calendar-year return for the 100% stock mix was -38.95% (unsurprisingly, in 2008); however, the maximum drawdown was far more painful. Your largest peak-to-trough experience was -52.48%[1]. In monetary terms, you would have had to stomach an account balance of $1 million on November 1, 2007, shrinking all the way down to $475,200 by February 28, 2009. That’s an extra $135,300 of losses and four extra months of suffering vs. the calendar year return measurement of 2008.
We ask clients point-blank, “Could you stick with it if we experienced these returns again?” History is only a guide; there’s no telling whether future downturns will be less or more severe than those of the past. Still, when discussing risk, we find the historical maximum drawdown to be a more useful metric than a risk score for managing expectations and measuring your willingness to take financial risk.
[1] Monthly returns from 2000 – 2024
Investment advisory and financial planning services offered through Falco Wealth Planning, LLC (dba Falco Wealth Management), a registered investment advisor. Past performance is not indicative of future results. Information provided is for educational purposes only and does not constitute investment advice.