When I first started investing in a 401(k), my company’s plan administrator asked me about my risk tolerance. Being in my 20’s, I considered myself an aggressive investor. So I confidently said I had a high tolerance for risk.
“Ok,” he asked me, “how would you feel if your account went down 20% in one day?” I was cocky enough to say, “Markets go up and go down. One day won’t scare me.”
He followed up with, “How would you feel if your plan went down 50% over six months?” Feeling a little less confident, I answered, “Well, I have a lot of time until retirement, I could ride it out.”
My advisor could’ve gone on and on, but I understood what he was doing. He was trying to make sure that I understood the potential risks and rewards of investing.
However, it was all theoretical until the market hit its first real downturn. No matter what you say your risk tolerance is, it’s sobering to look at a statement and see the value of your portfolio go down 8%, 10% or more in one quarter. That’s particularly true with a financial instrument like a 401(k) to which you’re making regular contributions. You can feel like you’re pouring money into a bucket that has a hole in it.
And it forces you to reconsider what kind of investor you really are.
Investing and savings are siblings, not identical twins
Having the patience to ride out a downturn in the market can be easier if your investments are truly investments and not savings. Most financial planners recommend that the money you are putting at risk as investments is money you won’t need for at least five years. If you’re going to need the money sooner than that, then you’re talking about savings. In both cases, you are paying yourself. But in the case of savings, you have plans for that money in the short term. You’re concerned about asset preservation more than asset growth.
Risk is a part of investing
This is one of the more interesting markets in my lifetime. On the one hand, equities are seeing swings of hundreds of points in a single day. Sometimes those swings can be caused by a single Tweet. As much as I want to believe that the market is still rational, there are times when I have to question how rational it is behaving.
However, any form of investing requires taking some risks. And when it comes to investments, the risk of playing it too safe is just as real as the risk of being too aggressive. Many of today’s retirees are keeping growth and income stocks in their portfolios because it is a way for them to achieve capital growth they can’t get from the historically low rates on fixed income products.
But risk is something that can be hard to identify when the market is going up. In the ten years prior to 2018, most investors grew accustomed to a market that went up. Then the global economy began to weaken, there was the talk of tariffs and trade wars. It was not uncommon for the market to rise and fall by hundreds of points on the same day.
For many investors, that was the final straw. They pulled their money out of equities and into the relative safety of “safer” financial instruments like bond funds. Is that the wrong move? It’s a question that only they can answer based on time and their personal goals.
Time can be a friend or an enemy
An old school pearl of wisdom is stocks beat bonds; bonds beat cash. The lesson is that when you look at historical graphs, the long-term trend for stocks has always been up. Investors that try to time the market will almost always have a portfolio that underperforms the broader market as opposed to investors who buy stocks and leave them alone.
That’s easy to do when the S&P 500 is averaging a double-digit gain. It’s a little tougher when the market is not doing well.
An investment plan is one that is right for you
It sounds like common sense, but every investor has different goals. As I wrote earlier, when the market is going up, investors tend to put their investments on autopilot. Some of this is based on the fear of missing out (FOMO). If everyone around them is seeing double-digit returns than why shouldn’t they?
But FOMO and other emotional responses can distract you from your individual goals. It could be that a time like this is an ideal time for you to take some profits out of the market before they are put at risk. Risk tolerance is always about asking yourself, “How much am I comfortable losing without any assurance that I will earn it back?” That’s a question that isn’t easily answered until there’s a downturn in the market.
There’s nothing wrong with discovering that you’re not as aggressive (or as cautious) as you thought you were. And it’s never too late to adjust your investment plan to fit your new-found tolerance for risk.