What to Know about Risk and Stock Market Volatility
Jay Abolofia, PhD, CFP® is a fee-only, fiduciary & independent financial planner in Waltham, MA serving clients in Greater Boston, New England & throughout the country. Lyon Financial Planning provides advice-only comprehensive financial planning for a flat fee to help clients in all financial situations.
US stocks have dropped 30% over the last month as a result of the Coronavirus outbreak. This has been a sobering reminder that stock returns are inherently uncertain and volatility is always lurking. Consider history. US stocks lost 54% in the Great Recession of 2008-2009, 47% in the Dot-Com Bubble of 2000-2002, and nearly 90% in the Great Depression of 1929-1932. Japanese stocks lost 46% during the crash of 1989-1990. 15-years later they were down 80% from their peak. As of this writing, 30-years on, they remain down 55% (see figure below).
Nikkei Stock Average, Japan, 1989 to Present
Plan for the Uncertain
Although markets are incredibly efficient, stock returns are uncertain and history has shown that they can be amazingly erratic. So, what are investors to do? In one word, PLAN. Plan for an erratic future. Plan for the next market crash. Educate yourself, focus on what you can control, and tune out market noise.
A sound investment plan begins with selecting an appropriate asset allocation, the percentage of stocks and bonds in your portfolio, in-line with your risk tolerance and risk capacity.
Consider Your Tolerance For Risk
Your risk tolerance is your emotional ability to withstand losses without panicking. To discover your risk tolerance, you need to consider the following question:
What would you do if stocks dropped 50%?
This is an incredibly difficult question to answer. In fact, you might never know for sure until it actually happens. No matter how hard any advisor tries to persuade you, your risk tolerance cannot be computed via a questionnaire. Ultimately, you need to imagine the pain your future self might feel if you were to lose a big pile of money. For example, if 80% of your $1M portfolio were invested in stocks, you’d lose $400K. (And, as the history of Japan illustrates, there’s no rule that markets must rebound in time for you to fund your goals.) If such a loss would cause your future self to sell in a panic, you’ve gone beyond your risk tolerance. You’re holding too much stock.
Consider Your Capacity For Risk
Your risk capacity is your financial ability to withstand losses without having to reduce your living standard. This addresses the question of how much risk you can afford, rather than tolerate, to take with your investments.
As with your tolerance for risk, there is no questionnaire that can accurately estimate your capacity for risk. It depends on a variety of factors on your lifetime balance sheet, including your human capital, financial capital, guaranteed income, and committed and discretionary spending (see figure below).
For instance, your human capital is positively related (+) to your risk capacity. The greater and more stable (bond-like) are your future earnings, the more stock you can afford to hold in your investments, and vice-versa. For example, if you’re younger or a tenured professor, you can afford more risk than if you’re older or an investment banker. The same positive relationship (+) exists with financial capital and guaranteed income. The more savings you have in the bank or income you expect to receive from guaranteed sources like Social Security, income annuities and pensions, the more stock you can afford, and vice-versa. (Ironically, the more savings you have the less risk you actually need to take.)
A negative relationship (-) exists with your spending plans. The greater are your committed expenses, like those on housing and education, or your discretionary (living standard) expenses, like those on food and leisure, the less stock you can afford to hold, and vice-versa. For instance, if you’re committed to living in a high-cost area and sending your kids to college you’ll need more resources to fund those expenses, which means taking less risk with your investments. (However, having flexibility with your spending plans can provide additional capacity.)
Conclusion
No one can predict future stock returns. The only guarantee is a bumpy ride. The recent market downturn is just one example in a long history of market volatility—and there will be more. To best prepare, educate yourself about the fundamentals of investing and revisit your tolerance and capacity for risk regularly. Try to never hold more stock in your investments than you can tolerate or afford. If your investments are down and you’re concerned, don’t make any drastic moves. Revisit your financial plan and consider if your long-term goals have changed.