As Warren Buffet famously said, “The first rule of investing is don’t lose money. The second rule is don’t forget rule number 1.”
But when you’re watching major indices decline rapidly over days, will Buffet’s word prevail or will the urge to hit the sell button rule?
Panic selling can do more harm than good
Conceptually, many investors understand why panic selling is never a good idea. You’d be converting your paper loss to a permanent loss, and you may miss out on the market recovery. According to a study by JPMorgan, if you missed the top 10 best days in the S&P 500 over a 20 year period from 1999 to 2018, your total return would be half that of an investor who remained fully invested throughout.
If you missed the 20 best days of the market, your return would go from positive to negative. This is because many of the best days in the market come right after the worst days. The same JPMorgan study found that six of the 10 best days occurred within two weeks of the 10 worst days.
That’s why it’s so important to understand your own risk tolerance and figure out your risk profile. Selecting a portfolio that fits your personal risk tolerance is key to ensuring you don’t make investment decisions you may later regret.
How much can you stomach?
To determine whether you’re at the right risk level, first ask yourself how much risk you can realistically tolerate. A useful exercise is to think about how you reacted during the 2008 financial crisis (or imagine how you’d have reacted).
Did you sell all your investments in fear; suffer sleepless nights and sell 50% of your portfolio; or did you choose to maintain your portfolio and not sell?
For a more nuanced evaluation of your risk tolerance, consider taking a risk assessment. Many digital wealth managers like Syfe have their own risk questionnaires. Banks and other investment firms offer them as well.
Understanding your risk capacity
The second step is to consider your risk capacity. This is closely tied to your investment horizon. Younger investors can generally afford to take on higher risk as they have more time to ride out the inevitable rough patches. They can allocate a higher proportion of stocks to their portfolio since stocks tend to outperform bonds over the long term.
For investors who have a shorter investment horizon, such as those nearing retirement, having a larger percentage of their portfolio in less-risky assets like bonds will be a better option since they may not have sufficient time to recover from any large losses.
Do you need to take the risk?
The last step is to think about whether you need to take the risk. Determine the investment return you will need in order to meet your financial goals. If you only need a 5% return, it might be unwise to take on excessive risk.
If you need a 12% return but are not comfortable with the additional risk you’d need to take, it may be time to reassess your goals – or think about whether you can increase your savings rate.
How else can you manage investment risk?
Taken together, your risk tolerance, risk capacity and risk requirements form your overall risk profile. A good wealth manager will be able to help you select the right risk level for your portfolio based on your risk profile.
Determining your ideal portfolio risk level essentially boils down to your asset allocation. A larger proportion of stocks in your portfolio will mean your portfolio risk is higher – but you may enjoy potentially higher returns as well.
A well-diversified portfolio is also essential to managing investment risk. Ideally, your portfolio should have holdings across different asset classes, sectors and geographies. For example, if one sector is underperforming, there could be other sectors that are doing better. Overall, this helps reduce the impact of market volatility on your portfolio.
Now that volatility is back, give your risk profile and portfolio risk level some thought. Don’t wait until the worst has happened to find out what you can really handle in terms of risk.