Risk is everywhere. A big part of an investor’s job is recognizing and accounting for that reality in your strategy and decisions.
The recent escalation in U.S.-North Korea tensions definitely falls into the risk category. Global markets were rattled over the past week as President Trump and North Korea’s leader, Kim Jong-Un, exchanged pointed rhetoric. The S&P 500 index (SPX) posted its biggest one-week loss since March and the CBOE Volatility Index (VIX) spiked to its highest close since November.
While market nerves appeared to have cooled this week, the saber-rattling over North Korea’s nuclear weapons program serves up a critical and timeless question for investors: This is risk – are your prepared?
“If you haven’t checked your portfolio in a while, this might be a good time to do it,” says JJ Kinahan, chief market strategist at TD Ameritrade. “Is your allocation and your risk profile what you want it to be?”
For investors, risk comes down to the probability that actual returns on investments will be lower than the expected return – including the possibility that and entire investment will be lost. Exposure to various risk factors literally covers the map – from countries and regions and their inherent geopolitical conditions, to interest rate risk, liquidity risks and more.
A “Heads-Up” on Risk Exposure
Geopolitical events are particularly nettlesome, given the potential for surprises and the difficultly in accurately predict outcomes.
The U.S.-North Korea standoff, like other geopolitical situations involving tough talk, is “very much a wait-and-see game,” Kinahan says. “But the market is giving you a heads-up to make sure your risk exposure is what you’re comfortable with.”
This is “telling you to be a bit more aware of everything that’s going on in the market.”
Over the past 60 years or so, global flare-ups sent stock markets into temporary declines many times. But in many cases, markets recovered losses in the following weeks and months, and sometimes even moved even higher, indicating that these short-term sell-offs are seen as buying opportunities by some market professionals. Of course, what has happened in the past is not a guarantee of what will happen in the future.
In the initial days of the Cuban Missile Crisis in October 1962, the Dow Jones industrial average actually rose 1.1%; about a month later, the Dow was up 12.1% from the crisis “reaction date,” according to Ned Davis Research. The Dow fell as much as 13.3% after Iraq invaded Kuwait in August 1990; about a month later, it was up 0.1%, and three months later was up 2.3% from pre-invasion levels.
Those two events were among 53 crises analyzed by Ned Davis Research going back to the Financial Panic of 1907; In all but 13, the Dow was higher than the reaction date three months later. Among all events, the Dow’s mean initial decline was 6.6%; the mean performance three months later was a gain of 5.4%.
“Black Swan” Dive?
Many veteran market observers so far are sanguine on the longer-term implications North Korea tensions, while acknowledging the prospect for a “Black Swan” event that shocks the world.
Patrick O'Hare, chief market analyst at Briefing.com, said it’s long been accepted that North Korea is a “thorn in the world's diplomatic side.”
“Yet no one in their right mind would have shorted the stock market at the start of the year based on the belief that North Korea's longstanding history of bellicose rhetoric toward the U.S. would translate into an actual nuclear conflict,” O’Hare wrote in an August 11 report.
“We're hard-pressed to think the stock market really thinks a military conflict— let alone a nuclear conflict -- is going to happen,” O’Hare says. “But, what if the stock market is wrong? It's not an answer we want to learn, yet it's fair to say that a war with North Korea would be a Black Swan event.
For the individual investor, a big part of the job is to not only be aware of risk and the potential impact on your portfolio, but define and quantify how much risk you can stomach – aka, your “risk tolerance.”
Aggressive vs. Conservative
Risk tolerance can be defined in a few different ways. In general, investors with “aggressive” risk tolerance have a deeper understanding of financial markets, and are financially able to weather investing in volatile products such as small company stocks, alternative investments, and leveraged instruments such as futures.
Those with “moderate” risk tolerance might accept some principal risk, but typically tend to favor a balanced approach. And if you stick to products that are highly liquid and come with some form of principal protection (such as certificates of deposit or U.S. Treasury securities), your risk tolerance would most likely be considered “conservative.”
Kinahan says investors should ask themselves a few fundamental questions that address their comfort level with risk exposure.
“Every individual should know what their risk tolerance is,” he says. “Is it reflected in your portfolio? Are you taking more risk than you’re comfortable with? Are you over-allocated in one particular stock or sector?”
For example, a portfolio that was 20% allocated to one industry or sector at one time may now be 40% in the wake of a rally. That may be time to re-allocate. “Whatever action you need to take, take it,” Kinahan says.
Choice Is Opportunity
TD Ameritrade offers a variety of account types and investment products to fit your needs.