How is your stomach for risk tolerance?
At the time of this writing, the S&P 500 has a -22.97% return YTD in 2020. As we look at investing from an analytical standpoint, it is reasonable to assume this is just another market crash. Similar to the dot-com crash of early 2000’s, the mortgage backed lending financial crisis in 2008, and a collection of other dramatic financial events in the history of the stock market. In the long run, it is reasonable to predict that human progress will continue to drive long-term financial success in the markets.
But, that doesn’t mean that the financial events caused by the coronavirus should be ignored. The recent stock market decline has provided an excellent barometer for your risk tolerance.
What is Risk Tolerance?
Risk tolerance is simply your ability to withstand fluctuations in the markets, which does mean the occasional loss.
The more risk tolerance you have, the less concerned you are with short term fluctuations. The converse is also true, the less risk tolerant you are, meaning you are risk averse, the less you are willing to lose money even in the short term.
Why is this important?
Depending on where you are in your investment life cycle, you may want to adjust your risk tolerance. For example, if you are young and just getting started investing, you likely will be more willing to take losses for the chance at higher gains. Young people typically don’t have as much to lose, and have time on their side to weather out any financial storms.
As you get older, and that nest egg grows in size, many people become less risk tolerant. This is especially true when you are getting closer to the age of retirement, when large swings in the stock market can drastically impact your financial fortress, when you need that money most. For more information on the impact of stock returns on your retirement, check out our article on sequence risk.
Why is this important now?
For the past decade, the stock market has been on one of the longest upward runs in history. This likely influenced people’s self-evaluation of their risk tolerance. Seeing gains day after day for 10 years increased the FOMO (fear of missing out) of those prosperous times. It is quite easy to say you are “open” to the normal fluctuations when all you see is those double digit returns in the black.
The early part of 2020 has been a reality check for many people. Those negative returns have opened people’s eyes to the realities of investing in the short term; sometimes you win, sometimes you lose. If you have found yourself losing sleep over the losses incurred over the first quarter of 2020, perhaps your risk tolerance was set too high.
This is something you need to evaluate for yourself, taking into consideration your unique situation. Are these recent losses impacting your ability to enjoy life? Are they causing an undue amount of stress? Or perhaps you were right in your assessment of your risk tolerance, and you aren’t fazed. Maybe you even recognize the tremendous opportunities that lie in the crashing markets.
What to do if you’ve misjudged your Risk Tolerance?
Irrespective of the investing choices you may have made in the past, it is important that level heads prevail. If you think you were previously too risky, do not sell at a loss if you have any other options available. While nobody can tell how long the markets will be depressed, or even how low they will go, one thing is certain. We will survive. And, just as importantly, we will thrive again. What you can do going forward is change the asset mix that you invest in on a regular basis. By making an adjustment on your future contributions, you will over time change the asset allocation mix of your overall portfolio. This way you can learn from recent events, and avoid locking in any temporary losses.
Investing provides a way to make your money work for you. But it isn’t a guarantee that you will always like the outcome, especially in the short term. Understanding your risk tolerance will help you invest wisely, and sleep better at night.