What 2022 Taught Us About Risk

by Brad McMillan, CIO, Commonwealth Financial Network

For investors, 2022 has been a tough year. We had bear markets in both stocks, which is fairly common, and bonds, which is not common at all. They both happened at the same time, so rather than being saved by diversification, portfolios got hit twice. Even portfolios that were designed to weather market storms, such as a typical 60 percent stocks and 40 percent bond allocation, were hit harder than anyone expected. 2022 was an exceptional year and not in a good way.

What made the year so difficult was that risk popped up in a way that no one really foresaw. With all of the worries at the start of the year—Covid-19, the Ukraine war, and everything else—the spike in inflation and the consequent rise in interest rates are what shook markets. As usual, the bus that hits you is not the one you are watching.

Reflecting on 2022

So what can we learn from 2022 and take into 2023? I strongly suspect inflation and interest rates won’t be the surprising story of next year. It's not because the data is improving, although it is, but because those expectations are already thoroughly incorporated in the markets. It also won’t be a recession, if we get one, because everyone is expecting that. Instead, it will be something on the back pages of the paper that no one sees as a major factor at the moment. We don’t know what could knock markets, but we know something might. Given that, what are the lessons of 2022?

First is that bear markets happen. Not to be flip, but this is something investors regularly forget, especially after a couple of good years. We will see sustained market pullbacks from time to time, and last year will not be the last. In 2022, after some good years, investors were shocked by the market pullback. This should not have been a surprise, as pullbacks happen regularly. So, remember to expect a downturn.

Second, on a related point, when you plan your portfolio, there is nothing wrong with cash or cash-like assets. Cash is a missed opportunity when the market goes up, but it is both a cushion and an option to buy more when the market goes down. Having some cash in the portfolio is not a bad thing, especially in 2023 when you will be getting paid to wait.

Third, and perhaps most important, is that one year—no matter how good or bad—doesn’t achieve or derail your goals. It’s a multiyear process, and if your plan incorporates the fact that bear markets happen and is designed to survive them, then one year really doesn’t matter. This too will pass.

Knowing Your Risk Tolerance

The final point to take away from 2022 is that it has been a valuable lesson for us all. Once again, investors have had a chance to learn how much risk tolerance they really have. If 2022 shook you, then there is no shame in derisking—it may be the smart thing to do over time. It’s better to go slower and get there than to go faster and crash. When you look at your end-of-the-year statements, ask yourself whether you are comfortable with the outcome. If not, talk with your advisor and make changes.

Tomorrow, I will talk about some specific things I do to manage risk—both what I do now and what I will do differently in 2023. Nothing significant has changed, but I’m making some adjustments to my approach, both personally and for my clients, that might be interesting.

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Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation's largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth's investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.

Forward-looking statements are based on our reasonable expectations and are not guaranteed. Diversification does not assure a profit or protect against loss in declining markets. There is no guarantee that any objective or goal will be achieved. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is not indicative of future results.

Commonwealth Financial Network is the nation's largest privately held independent broker/dealer-RIA. This post originally appeared on Commonwealth Independent Advisor, the firm's corporate blog.

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