Risk: How Much Can you Take?
Do you know your own capacity for risk?
Aside from capital loss, another risk that is causing a lot of anxiety lately is volatility risk. Most of us realise that stocks go up and down, but the kind of dramatic moves we’ve seen lately have tested the mettle of even the most intrepid investors.
Volatility: Accelerating the Cycle of Fear and Greed
Volatility can harm portfolios in a couple of ways. First of all, when it comes to volatility, timing is everything. All investors will undoubtedly experience their share of market turbulence, but it really matters when those ups and downs occur. For example, volatility can be especially painful for recent retirees, who have seen their retirement savings slashed considerably. Although the markets will eventually come back, retirees’ portfolios have less time to recover, and the recent downturn could have a significant impact on the amount they are able to withdraw to meet their income needs throughout their retirement.
But perhaps the most insidious aspect of volatility is its impact on investor behaviour. When markets gyrate as they have lately, emotions can get the best of investors and tempt them into making the counterintuitive move of buying high and selling low.
We see the same sort of behaviour on the upside too. Whenever a fund puts up big numbers, investors pile in enthusiastically. But funds that generate outsized returns are almost always taking outsized risks. Once those risks become apparent and the inevitable correction occurs, the same investors often jump ship. Our research on investor returns, which are adjusted for the timing of shareholders’ purchases and sales, has shown that investors generally don’t use volatile funds well. Investor returns for volatile funds are often significantly less than the funds’ total returns, which don’t reflect the timing of cash flows.
Know Your Risk Tolerance & Invest Accordingly
To guard against such behaviour, you need to have a clear understanding of your own capacity to endure volatility. It’s been said that if you don’t know who you are, the market is an expensive place to find out. And for better or worse, the market is giving investors a gut check right now. To invest wisely and profitably, you need make an assessment of your ability to tolerate market downturns. Arming yourself with an honest appraisal of your capacity for risk, you can then invest accordingly. If you’re a cautious sort, it may be best to steer clear of volatile market segments, or better yet, construct a portfolio of minimally correlated assets to arrive at a volatility level you can live with. (See our article on diversification, here.)
The need to minimise volatility becomes paramount the closer you get to your investment goals. The nearer you are, the greater the role of bonds and more stable asset classes should play in your portfolio.
