When the S&P 500 plunged by 34% back in March as the economic damage of the coronavirus pandemic started to become apparent, few people could have imagined what would happen next. In less than five months, the broad stock market index reversed course a reached a new record close.
The reversal of the tech-heavy Nasdaq Composite Index was even more dramatic. After bottoming out in late March, the Nasdaq needed just three months to surpass its previous record and soar past the 10,000 mark for the first time. Less than two months later, the Nasdaq topped 11,000. Remember, the Nasdaq fell to 6,860 on March 23.
Risk vs. Reward
The high levels of volatility we’ve seen in the stock market this year are a stark reminder of the risk vs. reward nature of stock market investing. If you hadn’t thought much about your investing risk tolerance lately, you probably have in recent months as the stock market has embarked on a series of dizzying highs, lows and highs again.
It’s critical to honestly assess how much risk you’re willing to assume with your hard-earned investment dollars. Otherwise, you could experience undue stress during times of extreme volatility like we’ve experienced recently.
As you perform this assessment, it’s helpful to view your investing risk tolerance through the lens of how human beings process risk in general. The fact is, for most people, the fear of losing is greater than the excitement of winning.
For example, when flipping a coin, there’s a 50-50 chance that you’ll make the right heads or tail call. But when given the chance to bet $100 at even odds on making the right call, research has shown that most people will pass on this bet. In fact, it takes a payout of nearly double the amount at risk — or in this case, almost $200 — to get most people to play due to their fear of losing money.
Loss Aversion and the Stock Market
So how does this loss aversion apply to investing in the stock market? The average bull market lasts 7.5 years and offers a total upside return of almost 400%, while the average bear market lasts 1.5 years and features a downside risk of around 40%. Even though this would indicate that the potential upside of investing in the stock market is far greater than the potential downside for long-term investors, many people prefer to remain conservative and stay away from stocks.
Now let’s apply this thinking to what we’ve seen in the stock market so far this year. Some investors who hadn’t honestly assessed their risk tolerance before markets plunged in March may have sold stocks in a panic at or near the market lows due to loss aversion. In doing so, they missed out on the strong bounceback the stock market has enjoyed since then.
In other words, these investors bought high and sold low — which is the opposite of a successful investing strategy.
Takeaways to Remember
Here are a few important things to keep in mind as you assess your investing risk tolerance:
- Remember your investing time horizon. If you are investing to meet long-term goals like saving for retirement or your young children’s college educations, you should try to ignore short-term market volatility. It’s understandable that you may have an emotional reaction to volatility, but if your time horizon is 10 to 20 years or longer, you have time to potentially recoup short-term losses.
- Think about your capacity for loss. In other words, how equipped are you financially to absorb investment losses? Do you have resources other than your investment portfolio that can cover your expenses? With a retirement portfolio, for example, do you have a pension or inheritance that can also help pay your retirement living expenses?
- Keep disaster scenarios in perspective. When it looks like the sky is falling, our minds often have a tendency to process worst-case scenarios and project these into the future. This is true whether we’re talking about a 9/11-style terrorist attack or global disease pandemic. But these worst-case scenarios are far from inevitable.
A Highly Personal Assessment
Risk tolerance is highly personal — no two people have exactly the same level of risk tolerance. Therefore, it’s important not to be influenced by what you might read or hear in the press or among friends and acquaintances about what the “right” risk tolerance might or might not be.
Give us a call if you’d like to discuss risk tolerance in more detail. We can help you determine your level of risk tolerance and plan your investing strategies based on this.