Risk tolerance questionnaire

Did you panic in March 2020 during the market drop?  How did you react to the wild market swings?  I’ve been hearing many stories of investors holding cash all summer waiting for the market to drop again because they panic sold at the worst time.  If you’re one of those people, the asset allocation of your portfolio was probably too risky for your tolerance.  To properly know how much risk you can tolerate, you need to evaluate your portfolio before the next market crash.  If you’re evaluating your risk tolerance during wild market moves, you’re already too late.

There is a great quote from Mike Tyson that perfectly summarizes my thoughts on risk tolerance and the stock market:

Everyone has a plan 'till they get punched in the mouth— Mike Tyson

In other words, if your “plan” involves taking too much risk, and then panicking when you get punched in the face, that wasn’t much of a plan in the first place.  I often see investors who think they can “dodge the punch” and their plan involves being able to guess the moment before the market crash.  The reality is that most people can’t see the punch coming until its too late.  The market rarely does what people think it should, especially in the post-coronavirus world.

Assessing your risk tolerance

Investing time horizon, age, goals, comfort, and current wealth/income are all important considerations for calculating your risk tolerance.  Ultimately, your risk tolerance is your ability to withstand losses without selling.  Why does it matter so much if you sell?  Hundreds of years of data across multiple markets, depressions, recessions, and market bubbles all point to an important truth about investing:  People that hold their investments for long periods of time make money.  Lots of money.  There is no better predictor of success.  One of the best predictors of failure is giving into panic and other behavioral biases.

Time Horizon:  Even younger investors might have money invested that they need within a few years for a house deposit, relocation, or other large expenditure.  If you need access to your funds within 5 years you shouldn’t be taking as much risk as someone that has a 30+ year outlook for using that cash.  The stock market averages 7% in growth each year, but there are valleys, dips, and depressions along the way.  There might be years where the market is down more than 20%.  A longer investment time horizon allows for the averages to balance out.

Age:  Younger investors can weather market downturns and “wait out” periods where the market is underperforming.  Older investors that are dependent on their investments for income are particularly vulnerable to market downturns.  Remember, a 50% drop in your portfolio requires a 100% gain to recover (100 to 50 = -50%, 50 to 100 = +100%).

Goals:  Investing is much more complicated then “try and make as much as possible”.  Gambling is easy.  Making consistent returns that help you meet your retirement, home ownership, career, and legacy goals requires specific process.

Wealth:  An investor with an extremely large portfolio is going to be able to weather market downturns much more easily than folks that are completely dependent on their savings.  Retirees with additional sources of income (pensions, business cash flow etc.) are also able to take more risk, because there is more room to accommodate losses in their overall investment plan.

Comfort:  People are different.  Some can sleep easily at night with heavy losses, others suffer debilitating anxiety over even small losses.  If you’re suffering extreme anxiety over your investments, or checking them daily, that is a sign that your allocation is too risky and should be adjusted.

What are the next steps?

Investing in the stock market without an evaluation of your risk tolerance is like getting punched in the face by Mike Tyson, *then* figuring out what your plan will be (hint: it’s too late).  At Arrow, we have our clients answer a series of questions about their anxiety and reactions to market volatility. This is part of your Investment Policy Statement (IPS) and allows us to come up with a plan that is appropriate for your age, time horizon, goals, and comfort.  It’s also possible that you might be investing too conservatively and hurting your future self by limiting your returns.  Our interview process is designed to find your perfect balance.  Your investments should never keep you up at night, and if your asset allocation is built correctly, you won’t panic during market turmoil, and end up wealthier over the long-term.