How much risk can you handle?
It’s probably the most important question in investing. If you can deal with a lot of volatility, then you can have more of your portfolio devoted to equities. Over time, because equity investments are a portion of ownership in a company, they benefit the most if the company grows. But if the company sees any trouble, or even if it just stagnates, the value of that equity investment will fall.
Not so with bonds. These “steady Eddies” return the capital to the investor with interest. Only the worst sort of misfortune could cause nonpayment. They also bear other kinds of risk, depending whether the interest they pay is fixed or floating, but they’re essentially an investment with little upside but with even less chance for a loss.
There are other risks, and investments designed to profit from them: foreign exchange, the cost of materials, inflation, even weather and natural disasters. All of these items add volatility to a portfolio and increase its potential return. Many people figure they can handle the risk—until they can’t. They want the excess return just up to the point where it starts to go down. That’s not risk-tolerance, that’s recklessness.
A person’s ability to withstand risk and their attitude about risk are two separate things. Both are critical. If you take risks without understanding what you can handle both emotionally and financially, you won’t be able to stay the course. And sticking around through the downside to benefit from the later recovery is essential.
Only by understanding yourself well—your total financial picture as well as your personal psychological make-up—will you be able to withstand the ups and downs. Anything else is just speculation.
Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!
Follow me on Twitter @GlobalMarketUpd