Staying in Your Lane When It Comes to Investing
By Brian Aberle
In the cult classic movie "Office Space", the opening scene has long been one of my favorites. In the scene, the poor guy is stuck in rush hour traffic only to see the lane next to him open up and start moving. Then, as soon as he switches to the "faster" lane, it stops, and his old lane starts moving. His benchmark within the movie is an older gentleman who requires a walker for assistance. It’s funny and yet frustrating because we’ve all been there, both in traffic and, yes, with investing.
Within the world of finance, investing is is often analogous to driving down the freeway. As investors, we, in lockstep with millions of others, orchestrate a somewhat symbiotic dance, 99% of the time, without much drama. We go about our business, often sticking to our respective lanes without so much a thought about the potential issues ahead. Other times, it seems as if the market/traffic gods are against us. One metaphorically blown tire gums up traffic, whether it’s a recession or just a schism that causes markets to seize up or reverse. When this happens, our emotions as investors flair up, but it tends to be fear when investing instead of anger when driving. We then become the guy in the video.
When markets are good, sometimes too good, we feel like we’re losers hanging out in the slow lane. We want to be where the action is. Our brains become convinced by market data, or just the opinions of others, that with speed comes our destination, like retirement, quicker. We drive faster, get a ticket or worse, have an accident, and pine for the good old days when we were in the slow lane. When markets decline, we get nervous. We often overreact to the events, and end up worse off than had we stayed put. We then look at the person sauntering on the side of the road, let’s call him Mr. Bonds, and think to ourself “that guy has no idea how lucky he is.” That is how our brains screw with us. Keeping our wits is at least 80% of the game in finance.
In this blog post, I’m going to dive into what it means to stay in your lane when it comes to investing. I’ll walk through the idea of setting your emotional tolerance for risk (speed, if keeping with the driving theme), your financial capacity for risk (how much you can afford to lose), and the process of rebalancing, which is akin to routinely making those micro-adjustments to the steering wheel so that you can avoid a big adjustment later on.
Staying in your Lane Rule #1 – Know Your Emotional Tolerance for Risk
It is safe to say that we are all emotional beings. Some of us can deal with our emotions better than others. When it comes to investing, emotions can destroy one’s investment strategy.
Understanding your emotional risk tolerance when it comes to investing means understanding how much volatility or fluctuation in your portfolio you can emotionally handle before deciding to pull the pin on your investment strategy. Some can handle seeing their portfolio down 40% and may not break much of a sweat. Well, they may be sweating a little. Others start to freak out when their portfolio is down 5%, wondering if we are approaching end times. Our emotional tolerance can also indicate our level of patience with our investment strategies. The lower our patience, the more likely we are to desire a switching of lanes when things aren’t working out optimistically in the short term. Perhaps we read about a new, cool investment or hear our relatives bragging at holiday gatherings and wonder if we’re missing out. We switch lanes and… you get the idea by now.
How to Know your Emotional Tolerance – Experience, Surveys, and Stress Testing
Experience may be the best way to know where you fit on the emotional spectrum when investing. I enjoy running class IV whitewater in a little plastic boat and enjoy surfing head-high waves. Yet, I am afraid of heights. A fifteen-foot ladder gets me knotted up. Why? I’ve boated enough rivers and subsequently have had enough swims to know what to expect. I don’t climb ladders that often, and thus my mind races with the variabilities that I can’t seem to quantify. The consequences seem so much higher even though they unquestionably are not.
But what if, as an investor, you don’t know your emotional tolerance or lack much experience. What can you do? One way to determine your risk tolerance is by using historical data and online tools to help you determine what might be appropriate for you. These tools look at past events and ask questions like, “imagine you lost 20% in three weeks with your investments; how would you feel”. If you thought to yourself, “I would start digging a hole in my backyard to bury my remaining cash,” you may not score all that great on the risk spectrum. If you thought, “maybe I would turn on the financial news for five minutes but otherwise get on with my day,” you might score higher. If you want to give yourself a simple test, I’ve attached a straightforward survey publically available online here by Charles Schwab that helps one to determine acceptable risk tolerance and thus which lane might be more appropriate. Check it out.
Compare your Tolerance to your Portfolio
Once you know your tolerance, it is essential to compare it to your current portfolio. Over the years, we have had many conversations with prospective clients who had portfolios that were nowhere close to their appropriate level of risk, often on the “too risky” side. I’ve met investors who were emotionally cautious yet fully invested in aggressive stocks. I have also met investors who had emotionally higher tolerances for risk yet are sitting on 80% cash waiting, for ten (twenty?) years, for markets to “drop so that they can potentially put money to work cheaper.” Trust me when I say that’s a thing too.
Within our practice, we utilize a comprehensive stress testing tool from Hidden Levers that works similarly to the Schwab survey but then takes the assessment a step further by providing stress tests and outcomes based on historical events and how assets correlated to those past events. The tool that we use helps to put history front and center. Were you still in diapers during the dot.com bust? No problem. We can show you how your portfolio today would have performed back then using backtesting and proxies. A sample snapshot of our tool is below. We can sit down with our clients and help them compare their emotions to the economic realities of their portfolio in both good and bad markets and even test to potential events like rising inflation, trade wars, or black swan type of events like depressions or these days, pandemics. We can look at portfolios as a whole and look at each holding to understand any outliers within portfolios.
If you wanted to check out our stress testing tool, reach out to us for a free assessment.
Staying in Your Lane Rule #2 – Know your Risk Capacity
“Can I Afford This?”
Our emotional risk tolerance is just one piece of the equation when it comes to investing. An often overlooked component is understanding our financial capacity for risk. Said another way, our risk capacity is what our checkbooks can cover when it comes to portfolio volatility. It’s often said that the younger you are, the more emotionally aggressive you can be with your investments. Yet, the truth is that youth tends to equate to a higher level of financial vulnerability. Maybe you are in a new career, have a new home and family. If you lack adequate financial safety nets like savings, then an aggressive investment lane may not be the best option. An economic or market shock could lead to financial challenges that are exacerbated when the assets you may need to tap are down substantially, adding insult to injury. This is because economic downturns tend to be highly correlated to challenging financial markets. If you lose your job (due to the economy) and have to raid your long-term investments to keep your home, you can see how this snowball effect can really trash your long-term situation.
On the other side of the spectrum, one could have a high capacity for risk. In this example, one has accumulated enough wealth or emergency savings to weather almost any financial storm. While the emotions may not agree, the checkbook will support high portfolio volatility. Maybe job security is high with ample retirement benefits, the house is paid off, and the kids have moved out. It’s that comfort of knowing that you could take on more risk if needed. Going back to the theme of this post, this could be the person who could easily afford a new car but still drives their 20-year-old diesel Mercedes while cruising down the slow lane on the highway. They could take more risk by switching lanes, but why? Conversely, we’ve met many retirees who have enough of a financial cushion to be able to create more aggressive risk investment buckets for 5-10% of their liquid net worth, understanding that if they lost 100% on that bucket, it wouldn’t be a deal-breaker for them. They opt to drive a faster car for the glory and can afford the tickets if you will.
Understanding your risk capacity is critical for long-term financial health. While questionnaires exist out there to attempt to understand capacity, a better way to understand your risk capacity is to have a financial plan. At its core, financial planning offers one the ability to put goals and concerns to paper. One can then stress test, much like we do with portfolios, against those goals and concerns and put together a plan of action. For example, if you are younger and have set aside savings to cover a loss of income for six months to a year; you have life and disability insurance to cover the low probability but high consequence events, then perhaps your risk capacity is now higher than before when such boxes were checked. If you are a retiree and your lifestyle is such that your odds of running out of money are extremely low, you may actually have a higher risk capacity than you think. Or, you could coast and not fret over market events, knowing you will be fine. Planning is a way to throw the financial what if’s at the wall, test them and figure out the best course of action.
Staying in Your Lane Rule #3 – Have a Rebalance Process
When we drive our automobiles, we instinctively make micro-adjustments to the steering wheel to stay in our respective lanes while still looking ahead. Without those adjustments, we would likely drift into a different lane (let’s hope it’s not oncoming traffic) in short order. As soon as we realize we are in a bad spot, what do we do? We aggressively whip the steering wheel one way or another to get back into our proper lane, right? I’ve been there too. Maybe we reach for the phone or the cup of coffee, and next thing we know, we’re inches from another vehicle.
When it comes to investing, most folks too often fail to recalibrate the portfolio steering wheel regularly. Too many let the good times roll, drifting a little further away from their lane, all the while not realizing their diversified strategy some time ago is no longer diversified. Then, when an adverse market event occurs, and investors in mass who have been lulled to sleep by the good times or having been distracted by what the cool kids are doing (crypto? meme stocks?), suddenly realize that they are no longer in their appropriate lane. When this occurs, the herd of investors seek in mass to “correct” their portfolio positioning, seemingly overnight, hoping to avoid a crash of their portfolio. A traffic jam ensues, with all investors seeking the exits at once or a different lane. Now you know what the term "market correction” really means. It is often the markets making a sharp, sudden adjustment from too much drift in optimism and greed.
How to Rebalance
The key to rebalancing and staying in your lane is to have a process that you can stick to. It may also go without saying, but in order to know how to rebalance, it is essential to know what your balance should be in the first place. If you are unsure of your allocation or your investment philosophy is the “wing and a prayer method,” consider skipping to rule #4.
Below, I will focus on two processes or methods, both of which we utilize within our practice, that with a little bit of work, you can do as well.
Time-based rebalancing is relatively straightforward. Regularly and often on a set schedule, the portfolio is rebalanced back to the original target allocation. Such a process aims to reduce the emotional timing decisions of when to buy and when to sell. For example, you have a portfolio that is 50% stocks and 50% bonds. After six months, the portfolio is automatically rebalanced, regardless of what is happening within the markets. The holdings are brought back to their 50/50 mix. Assets over their target allocation are trimmed, while the assets under their target are bought. If you have a retirement plan through your work, chances are you may very well have this option available if not already activated so that your portfolio rebalances automatically. If you are a DIY investor, it’s important to identify the frequency of your rebalance process and then see to it that the rebalance is done. Trying to keep your emotions out of it? Harder to do.
Drift-based rebalancing is less concerned about keeping a schedule. Instead, the objective is to create a level of acceptable drift or maximum exposure at the portfolio or down to the individual holdings. Going back to the 50/50 example, a drift-based rebalance would be structured so that if either position drifts more than 5% from its target, it is rebalanced back to its acceptable range. In the spirit of this blog, think of this as having guard rails. Thus, the stock position, if it exceeded 55% relative to the total, it would be sold, and the bond component, now below 45%, would likely be bought. It may go back to the original target allocation, or it may simply be adjusted to back in the acceptable range (below the 55% max). Large institutional investors often use the drift-based rebalance method to set a maximum exposure on an investment. Perhaps an initial investment allocation was originally 5%. The institution may have a rule that says no investment can be more than 10% of the portfolio. What do they do if said investment is now 11%? Trim it down to at least 10% or sometimes back to the original target.
At Aberle Investment Management, we utilize a combination of time-based rebalancing techniques and drift-based rebalancing techniques. Approximately every six months (usually February and August), we reassess the themes we have chosen for the basis of investing our client money. We then rebalance based on levels of drift that we set for each security. Typically that drift is around 15-20% but can vary from security to security. This means a holding with a target of 10% can go to say 12% on the high side, or as low as 8%, and still be properly allocated.
Staying in your Lane Rule #4 – Hire a Driver?
Maybe not so much a rule, but a suggestion that sometimes, as an investor, it may just be better to outsource the driving duties so that you can chill in the back seat and let someone else worry about helping you stay in the proper lane. In fact, the bulk of the financial industry, ourselves included, relies on most investors choosing this option. There often is an additional cost, but if you can find a trusted partner or tool that can help you with rules one through three, you can more easily stay in your proper lane and reach your destination with hopefully less drama. These days, one can choose to work with a human or outsource the duties to an algorithm or black box. It often comes down to personal preference, but know what you are getting and know what your emotions prefer. Do you trust yourself not to switch from one box to another at the wrong time? Ask yourself whether you can feel good about a tool managing your assets or a human. Statistically, autopilot works quite well on a plane but generally defaults to the human at the landing and take off.
Summary
As investors, it can often be challenging to know which risk lane you should be in, let alone stay in. You first have to figure out your emotional capacity for risk or how fast you are willing to drive. Second, it’s important to understand your financial capacity for risk. Can you afford to start over (a new car?) should your strategy crash and burn? Third, it’s important to identify a method for ensuring that you are staying in your proper lane; too much drift and you are stuck correcting, often around the same time everyone else is too. If you feel you could benefit by having someone help you navigate the road ahead, we welcome the opportunity to connect.
Until next time, thank you for reading.
Brian Aberle
Aberle Investment Management LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to consult with a qualified financial adviser or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future returns.