This fall has been a stressful roller coaster ride for many investors — harrowing and sometimes gut-wrenching. While we can’t predict exactly when the ride will end, it’s a good opportunity to take some time to analyze how you’re handling this wild ride. I want to approach the market’s turbulence by asking a personal question.
What’s your risk tolerance?
I ask that question when people visit me at Capital Investment Advisors. The answer is critical for both investors and their financial advisors. And it’s the lens through which I want to discuss the recent month’s sell-offs and overall bad news about the market.
Risk tolerance is what makes the difference in how individual investors respond to market volatility. After all, investing is a mix between what you think will happen versus what you can tolerate happening. So, risk tolerance is just another way of expressing how well you can handle volatility, meaning how much market drop you can stomach on any given day, week, month or year.
So, here’s the deal. When I ask about risk tolerance, I illustrate it like this: On a risk spectrum from all CDs being a 1 to all small-cap and emerging market stocks being a 10, where are you? Really?
Now, you and I both know that if you had to choose the best place to invest your money over time (particularly for income generation), and you were choosing between stocks, bonds and cash, stocks would likely win hands-down. That’s because, typically speaking and based on historical data, returns for stocks land in the 10 percent range, while bonds land around 5 percent and cash at 2 percent.
But reality-checking yourself before you answer is key. Like, understanding that unless you have an iron-lined stomach, you would likely choose to have a mix of these investment vehicles. For most people, it doesn’t work to go all-in on stocks because of the emotional toll it takes to watch your life savings lose value in a down market. Big swings in your allocation to this asset class, like going from 80 percent to 0 percent stocks to 50 percent and then back to 0 percent before making it 70 percent, tend to hurt more investors’ portfolios than help them. Doesn’t that feel exhausting just reading about it? Imagine doing it.
Most people can’t stomach either of the extremes; rarely is anyone a 10 or a 1. Most of us do fall somewhere in the midmost range, and plenty of folks I work with fall smack-dab in the middle at 5.
Let me share an example. Think of full-time hedge fund managers — people in the business of managing higher-risk portfolios. These are hyperactively traded investment strategies. They require day-to-day hands-on management and decision-making. And guess what? Even these folks can’t succeed with the back-and-forth “strategy” we outlined above.
While you may “know” that you should be 80 percent in stocks, or 60 percent in stocks, or whatever the number may be, if you go through a few weeks like the ones we’ve had recently and can’t sleep well at night, that’s your reality. And that’s OK.
That’s a gut check for where your risk tolerance is. And it’s important to know and remember. Maybe 60 percent in stocks is too much for you; maybe 50 percent is a better place for you to live.
Knowing where you lie on the risk tolerance spectrum is powerful information to have as an investor. It’s critical.
So, if you tell me you’re a 4 and I look at your portfolio and see it’s more like an 8, I know your asset allocation and risk tolerance are out of sync. And this is where we have problems. Like, sleepless nights and worry-filled days. We see more emotional reactions to the market when we’re in this realm, instead of being able to stay the course like we know we should.
The key is to know your risk tolerance and practice it in your portfolio. Right now may be a good time to revisit where you fall on the risk tolerance spectrum, and to ask yourself, “How much risk is too much for me?”
Remember to consider your time horizon, your goals and your income. And trust that over time, over the long haul or the very long haul, you can continue to work toward your objectives.
As a rule of thumb, there’s the 15/50 Stock Rule, which states that if you believe you have 15 years left on this planet, your portfolio should consist of at least 50 percent stocks, with the remaining balance in bonds and cash. The goal is to strike a constant balance between risk and reward. The stock allocation can be made up of either dividend-payers or growth stocks. You just need to keep an eye on your portfolio and reallocate as necessary to prevent stocks from creeping beyond the 50 percent mark.
Our bottom line here is that you shouldn’t expect to outsmart markets on a daily basis. Remember that time in the market beats out timing the market. And it’s not possible to smooth out the market any more than you can flatten a roller coaster. But knowing and working within your risk tolerance can make the ride a lot easier on your nerves and stomach.
The original AJC article appears here.
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