How Much Risk Should I Take?

This one comes from a family friend, Bill, who I ran into at a birthday party last week. He was absolutely fed up with the market volatility he'd been experiencing all year and wanted my opinion about selling the equities in his IRA and moving to cash. In his words, "Better to cut my losses now, because who knows how bad this could get?" 

Well, I get it. Watching the market drop and seeing the retirement funds you're counting on take a hit is not easy, especially after having lived through the debilitating recession of 2008. I acknowledge that there may be specific times that it makes sense to move to a very conservative position, but please hear this: developing a pattern of selling when the market is low and buying again when it is high can severely damage the long term growth of your portfolio. Every year the Dalbar organization studies historical investor behavior to gauge the impact of our decisions to buy and sell on our long term investment returns. The results are staggering. In their 2015 Quantitative Analysis of Investor Behavior, Dalbar showed that from 1985-2014 the S&P 500 returned right over 11%. Over the same time period, the average investor in equity funds only earned 3.79%. Why did the average investor earn so much less? Primarily because of the losses they experienced selling their equities when their values were going down and buying again when the prices were high!

So how do we respond to market volatility but avoid the losses of selling equities when there value has dropped? Well, this is where the concept of "risk tolerance" becomes very important - accurately judging the amount of risk you're willing to take in your portfolio. My friend Bill had not invested according to his risk tolerance. An analysis of the funds he was invested in showed that the losses he was experiencing were entirely within the normal range for the aggressive equity allocation he had chosen. In other words, those funds were performing normally! Bill had loved the significant growth his portfolio had experienced over the last few years, but he wasn't willing to stick around when they had a correction in the other direction.

We must be careful to invest according to how much risk we are honestly willing to take. Because if we get in a pattern of investing aggressively for growth, but selling and getting out every time the market drops, we can really damage our long term returns. That raises one other important question - how do we discern how much risk we're actually willing to take? The way you have responded to dropping markets in the past is the best place to start. Don't choose the risk tolerance you'd like to have, choose the one you've actually seen yourself act on. Far better to have a more moderate portfolio you can live with in good and bad times than one you will pull out of whenever the market dips.

If you'd like to analyze the aggressiveness of your current portfolio and how that matches up with your risk tolerance, we'd love to help! Click here to get started, we're looking forward to meeting you!