Herman Freitag, III CFP® | Associate Wealth Advisor
Investment professionals often advise clients to stay the course and remain disciplined, especially during market turmoil. While this advice seems counterintuitive in the throes of a market selloff, it is paramount for investors to avoid making emotional decisions during stressful times. However, this does not mean investors should refrain from reevaluating their investment strategy to ensure the course they initially embarked upon is still the right one.
The past decade has been relatively smooth sailing until recently when the market sold off 33.9% in the matter of 24 trading days . Fortunately, the S&P 500 has returned 31.9% after bottoming on March 23, 2020, leaving it –11.36% through May 15, 2020 . Having weathered this most recent storm, “risk tolerance” may mean something entirely different today than just a few months ago. Given the strong rebound, investors are fortunately close to being back on track and can now chart a new course that is more aligned with their newfound “risk tolerance”.
To better understand “risk tolerance”, it is helpful to break it down into two parts: risk and tolerance. With regards to investing, risk is a measure of the uncertainty in achieving expected investment returns. Statistically, risk diminishes the longer the holding period of an investment or portfolio. For this reason, one factor in determining a proper risk level is an investor’s time horizon. Reducing risk improves the certainty of future outcomes, which becomes more important as an investor’s time horizon shortens.
One way to reduce risk is by diversifying your investments into different asset classes like stocks, bonds and cash. Increasing the amount of bonds in a portfolio and reducing the allocation to stocks lowers the risk within a portfolio. The blend of stocks to bonds is commonly referred to as your “asset allocation”. This asset allocation is not only a driver of your risk, but also the investment returns.
Tolerance, the second, and oftentimes more important aspect of risk tolerance, relates to one’s personal ability to handle a portfolio’s fluctuating value. Considering the recent 34% decline in just over one month, how did you sleep during this period and what did you notice about yourself? Did you panic and mash the sell button, or did you buy the dip? Behavioral Economists have proven that investors make poor, emotionally driven, decisions when they are driven outside of their comfort zone. While selling in a market decline is often the mistake that gets the most discussion, the bigger mistake was made months, if not years before, by not understanding the level of risk one was comfortable with.
Personal risk tolerance changes as the size of an investment portfolio increases, meaning it must routinely be discussed and reevaluated. For young investors just getting started, a 50% decline in portfolio value may go unnoticed because the loss in terms of dollars is minimal. Most long term investors have accumulated significant wealth during the past bull market and watching several years’ worth of savings disappear felt different than past crashes. Investors have been conditioned to take excess risk over the last decade and have been rewarded for doing so. The perception of the stock market being risk free is simply not a reality.
There is no reason for investors to be surprised to have learned during the past couple of months that they are no longer comfortable with the current level of risk within their portfolios. Trying to properly determine your risk tolerance in a market that seems risk free, as the past decade has felt, is incredibly difficult. Regardless of where you were personally, now is the time to evaluate your risk, not in the middle of the next market meltdown.
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The statements and opinions expressed herein are subject to change without notice based on market and other conditions. The information provided is for informational purposes only and should not be construed as investment or legal opinion. Please consult a tax or financial advisor with questions about your specific situation. Investors may not invest directly in an unmanaged index. Past performance is not a guarantee of future returns.