The volatility that investment markets have experienced over the past few weeks serves as a good reminder of the importance of determining your level of risk tolerance. In other words, how much risk are you comfortable taking in order to achieve a certain level of investment return?
Risk is inherent in all investments, though some types of investments carry more risk than others. Stocks typically carry the highest degree of risk while cash equivalents (like bank savings and money market accounts) usually carry the lowest degree of risk.
Times of excessive volatility like we have experienced recently can test an investor’s risk tolerance. For example, if this volatility has resulted in high levels of anxiety and sleepless nights for you, then your risk tolerance might not be as high as you thought it was.
Investor or Speculator?
In his classic book The Intelligent Investor, Benjamin Graham encourages individuals to figure out their risk tolerance before investing money. More specifically, he recommends deciding whether you are an “investor” or a “speculator.”
Investors aim to “acquire and hold suitable securities at suitable prices,” Graham wrote. Conversely, speculators strive to “anticipate and profit from market fluctuations.”
For investors, market volatility represents “an opportunity to buy wisely when prices fall sharply and sell wisely when they advance a great deal.” Speculators, however, often sell securities when fear grips markets and prices fall. Of course, this is the opposite of a successful investing strategy, which requires buying low and selling high.
The main reason many people don’t achieve their long-term investing goals, Graham wrote, is because “they pay too much attention to what the stock market is doing currently.” He argues that the key to intelligent investing is exercising patience, independence and self control when making investing decisions.
In what appears to be very prescient given the market volatility we’ve experienced recently, Graham wrote that investors should reconcile themselves to “the probability rather than the mere possibility” that stocks will fall by 33% or more at least once every five years.
Important Questions to Ask
Consider these two important questions as you reexamine your risk tolerance in light of recent market volatility:
- What is your investing time horizon? Or in other words, when will you need to access the money that’s in your investment portfolio? If you have a long-term investing time horizon, you can generally afford to assume more risk because you’ll have more time to recoup short-term portfolio losses.
For example, if your investing goal is saving enough money for a financially comfortable retirement and you are in your 20s or 30s, you probably have decades before you need to withdraw money from your portfolio. Remember: Regardless of how much markets may fall in the short term, you haven’t actually lost any money unless you sell your securities.
- How do you handle market volatility emotionally? Even if you have a long-term investing time horizon, you might not have the kind of personality that’s equipped to handle extreme market volatility. If the sharp stock market drops of the past few weeks have caused you to worry excessively or lose sleep at night, then you may have a low level of risk tolerance and should structure your investment portfolio accordingly.
On the other hand, if you’ve been able to maintain an even keel through the daily ups and downs of the market and haven’t been tempted to make emotional investing decisions in the midst of volatility, you probably have a relatively high level of risk tolerance. In this case, you may be comfortable with a higher level of risk in your portfolio — especially if you have a long-term time horizon.
No Right or Wrong Answer
It’s important to realize that every investor has a different level of risk tolerance — and no certain risk tolerance level is “right” or “wrong.” You should gauge your own risk tolerance level based on these and other factors rather than on how other people like your friends and family are investing their money.
We’d be happy to discuss risk tolerance with you in more detail and help you structure your investing portfolio appropriately. Give us a call to schedule an appointment.