If you've been listening to the news lately, there's been a lot of reporting about the volatility of the stock market. Everyone's asking if it's time for a big drop. All the pundits have an opinion about whether we're due for a correction, a recession, and an end to the longest bull market in history.
Why Does Risk Matter?
In general, there is a relationship between the riskiness of an investment, and the average return it produces. Otherwise, why would someone invest in something riskier? As an investor, you should be compensated for taking risk. The stock market gets a lot of the headlines because it's risky. Riskiness usually means volatility. And that's where our emotions come in.
If you are constantly watching your investments and feeling a pit in your stomach when the market is volatile, there might be a mismatch between your psychological risk tolerance and your investments. Every person is different as to how they feel about investments going up and down. Some enjoy the ride, some think they should just stuff all their cash under their mattress.
Your risk tolerance may have been shaped by bad experiences during downturns. It might have been stoked by a family member who got rich by taking chances. It's tied to your emotions and can't really be explained rationally. That's ok. What's important is that you can sleep at night and ignore the headlines.
When is risk necessary?
There's another kind of risk you might want to think about. This is your ability to take financial risks and is more about your money than your emotions. The unfortunate thing is that the more money you have, the less risk you HAVE to take to reach your goals. You might be willing and able to take risk, but you don't HAVE to. It would be great if you could just figure out where you stand emotionally and set your investments based on that.
Where it becomes difficult for people is when their money and their goals aren't aligned, and to reach them it requires more risk than they feel comfortable taking emotionally. This is where difficult questions are needed as to whether goals can be modified, the timeline can be lengthened, or the amount invested can be increased to compensate. If not, you could end up in a situation where your investments are keeping you up at night.
What About Sticking Cash Under My Mattress?
A lot of people think cash doesn't have any risk. It is true that in the short term, your cash isn't all of a sudden going to lose 15% of its value. A dollar today is probably going to be worth a dollar tomorrow. But what about a year from now? What about 10 years from now? What about in 20-30 years when you are ready to retire? The unfortunate truth is that over the long term, cash is almost certain to provide a negative return due to the loss of spending power because of inflation.
So when it comes to your investments, think of Goldilocks. Try and find the portfolio that has just the right amount of risk for you. Not too much, not too little. If you need help finding that "just right" portfolio, reach out and get your Financial Planning Foundation today!