As stocks fell during the 2008-2009 financial crisis, many investors bailed out of stocks and fled towards less risky investments, regardless of their long-term risk tolerance level. Similarly, as stocks have risen during the recent bull market run, many investors have increased their stock allocation, regardless of their long-term risk tolerance level. This behavior prompts us to ask: Are these investors changing their allocation because their risk tolerance has changed over the last five years? Or is it that their perception of risk has changed based on the performance of the market?
Does your risk tolerance rise and fall with the market? Do you feel anxious when the market is down and carefree when the market is up?
Risk has many elements. One element of risk is required risk, the risk associated with earning the returns needed to meet an investor’s life goals and income needs. Another element of risk is risk capacity, which looks at what level of risk an investor can withstand, financially speaking. How much can an investor afford to lose before it affects their life goals? A third element of risk is perceived risk,which seeks to quantify how much loss an investor can tolerate from a psychological point of view. The problem here is that investors tend to be poor at predicting how they’ll react to market losses. For example, they might say that they can handle as much as a 40% loss in their portfolio; however, when the market drops 20%, they flee towards bonds and less risky investments.
The next time you are measuring your own long-term risk tolerance or are thinking of bailing out of or doubling down on stocks, consider all three elements of risk. If you are looking to reallocate your portfolio, make sure you are doing so because your risk tolerance has changed in response to changes in your life goals and not because your risk perception – or misperception – has changed in response to market performance.
If you would like to have a conversation about risk and see how we evaluate your portfolio’s risk, contact a GV Advisor.