Market shocks are an inevitable part of investing—but that doesn't make them any easier to stomach. Whether you're just starting out or you've been saving for decades, watching your hard-earned gains evaporate overnight can cause you to question the entire enterprise.
"When the market is going up and up, it's easy for investors to think they're more comfortable with risk than they actually are," says Mark Riepe, head of the Schwab Center for Financial Research. "But the S&P 500® Index's recent drop into bear-market territory may have forced people to confront their true risk tolerance."
So, how do you go about reassessing your tolerance for risk, come what may? Ask yourself these three questions.
1. How much can I stand to lose emotionally?
Investing is an act of faith—to say nothing of willpower. The assets that offer the highest potential reward are often the riskiest, but if you can steel yourself against occasional surges in volatility, you're more likely to reach your long-term goals.
The question is, how much risk can you really handle? To help answer that question, consider the downsides and upsides of five hypothetical portfolios:
More pain, more potential gain
Source: Schwab Center for Financial Research.
Data from 01/01/1982 through 05/31/2022 used in calculating annualized returns. Data from 1982–2021 used for Best and Worst performing years. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. Historical returns are weighted averages of the performances of the indexes used to represent each asset class, include the reinvestment of dividends and interest, and are rebalanced annually. The example does not reflect the effects of taxes or fees. The indexes representing each asset class are: S&P 500® Index (large-cap stocks); Russell 2000® Index (small-cap stocks); MSCI EAFE Index (international stocks); Bloomberg U.S. Aggregate Bond Index (fixed income); and FTSE 3-Month Treasury Bill (cash investments). Indexes are unmanaged, do not incur management fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
Although portfolios with larger allocations to stocks delivered higher returns over time, they were also more volatile—which may not work for everyone. If you need the money in the next few years, for example, you should choose a more stable investment mix. The same is true if you simply can't bear to see your portfolio plummet in value. "It's perfectly reasonable to say, I'm willing to accept lower returns in exchange for more stability,'" Mark says. "But that means you may have to save more—or ratchet back your spending expectations—to compensate."
Indeed, reducing your exposure to stocks and other relatively high-risk, high-reward assets during your peak earning years comes with its own kind of risk: falling short of your goal. "Market turbulence feels risky because it's something you have to face again and again," Mark says. "But the more pernicious risk comes from undercutting your long-term returns because there's often no coming back from that."
To help manage your emotional response to market volatility, consider cutting back on how often you review the performance of your long-term accounts. In fact, research suggests that the less often people check their investments, the more risk they may be willing to take—and the better their returns are likely to be over time:
Less is more
Source: Richard Thaler, Amos Tversky, Daniel Kahneman, and Alan Schwartz, "The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test," The Quarterly Journal of Economics, 05/01/1997.
Additional research also found that receiving price information less frequently led to professional traders (in a highly realistic experimental setting) investing 33% more in risky assets, which resulted in 53% higher profits than traders who relied on constant updates.1
"You can't wish your emotions away," Mark says, "but you can take steps to keep them in check." That said, there may be reasons to review your portfolio more often. "You should check in on your investments and your broader financial plan anytime your situation changes substantially."
2. How much can I stand to lose financially?
While many people think about risk in terms of their ability to endure losses emotionally, there's another component to risk that's equally important: your capacity to recover financially.
"Time is a big factor here," Mark says. "When you've got a decade or more until you need to tap your savings, short-term volatility isn't a big risk. But if you'll need the money in, say, five or fewer years, a market downturn can be devastating."
Be that as it may, your financial capacity for risk may not square with your emotional tolerance for it. An investor in his 40s, for example, probably has 20 or more years until retirement, which should allow him to invest aggressively. But some people simply can't tolerate the ups and downs of holding that much stock, regardless of their age or time frame.
Conversely, even aggressive investors can be waylaid by adverse life events like losing a job. "If you need to tap your long-term savings to help make ends meet, your capacity for risk can shrink overnight," Mark says.
"In such situations, downshifting your risk exposure to help preserve capital could absolutely be the right approach."
Of course, in a perfect world your financial plan would have a built-in cushion for such emergencies. For example, Schwab recommends having at least three (and ideally six) months' worth of essential expenses saved in a highly liquid account. "The COVID-19 outbreak demonstrated how quickly things can take a turn for the worse," Mark says. "With an emergency fund in place, you're less likely to need to tap your long-term investments to cover short-term expenses."
If you're nearing or in retirement, however, your emergency fund should be large enough to cover at least a year's worth of expenses, with another two to four years' worth saved in relatively liquid investments. "Keeping that much cash on hand will help you avoid having to sell assets during a downturn," Mark says.
3. How well do I know myself?
"Knowing yourself is the beginning of all wisdom," wrote Aristotle. Unfortunately, human beings are notoriously bad at predicting in advance how they'll actually respond to a given set of conditions.
That's why Mark recommends asking someone close to you to rate your risk tolerance. "You might think you're comfortable with risk, but your spouse or a close friend may be able to identify patterns of behavior—such as your tendency to play it safe in other areas of your life—that you're unable to recognize in yourself."
Financial advisors are ideally suited to this role because their experience with a broad range of clients can lend some perspective on where you fall along the spectrum of risk tolerance. As they get to know you, they may also be able to help you identify whether you're acting with your head—or your heart. "An advisor can help curtail the emotional responses that might otherwise get the best of you," Mark says.
In the end, figuring out how much risk you can really handle is an art as much as it is a science. "Sure, we can give you guidelines based on your age or time frame, but it ultimately comes down to how much you can stand to lose—both emotionally and financially," Mark says. "Once you know that, you can put together a plan that balances your long-term need for growth with your near-term need to sleep at night."
1Francis Larson, John A. List, and Robert D. Metcalfe, "Can Myopic Loss Aversion Explain the Equity Premium Puzzle? Evidence From a Natural Field Experiment With Professional Traders," National Bureau of Economic Research, 09/2016, https://www.nber.org/papers/w22605.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
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Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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