Do You Really Know Your Risk Tolerance?

Almost 75 years after it was written, Fred Schwed’s Where are the Customers’ Yachts? remains one of the most entertaining books ever written about the investment industry. Here’s one of its best remembered lines: “There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”

As Schwed recognized all those years ago, no one can really gauge their risk tolerance by filling out a questionnaire, or by pondering standard deviations. It’s easy to say that you have a long time horizon and you won’t panic in a downturn. But the fact is, no one really knows how they will react until they have actually lived through a devastating bear market.

And if you only started investing in the last few years, you haven’t been tested yet.

According to a Bloomberg article published earlier this month, the S&P 500 has now gone more than 1,000 days without a correction of 10%. The last time investors enjoyed a run like this was a 1,127-day period that ran from July 1984 to August 1987, the article reports. If you’re under 40 years old, it’s fair to say you don’t remember that one.

The situation is similar in Canada: the last time there was a 10% correction was mid-2011. The Horizons S&P/TSX 60 ETF (HXT), a proxy for the total return of Canadian large cap stocks, has not seen a 10% decline since August of that year—almost 1,100 days ago.

It don’t mean a thing if you ain’t seen those swings

Not only have we managed to avoid a significant drawdown for close to three years, the volatility of the markets has also been well below average. Have a look at the standard deviation of Canadian, US and international stocks in recent years:

Annualized Standard Deviation of Major Stock Markets (%)
Index 3 years 5 years 10 years 20 years
S&P/TSX Composite 10.15 10.65 13.84 15.20
Russell 3000 8.62 8.89 11.48 12.87
MSCI EAFE + Emerging Markets 11.26 11.24 13.42 13.58
Source: Dimensional Returns 2.0. Figures are in Canadian dollars. Period ending June 30, 2014.

As you can see, the volatility of returns in Canada and the US has been about 50% lower in the last three and five years than it was during the past two decades. For even more perspective, the Credit Suisse Global Investment Returns Yearbook 2014 reports that the return of US stocks had an annualized standard deviation of about 20% from 1928 through 2013. Since mid-2009, it has been less than 9% (when measured in Canadian dollars). That’s a leisurely float down a river without many rapids and not a single waterfall.

A time for calm reflection

So what is the lesson for investors? I think there are a couple. First, if you’re young and just getting started, don’t make the mistake of thinking your long-term journey will always look like the last five years. These days I hear from a lot of new investors who say they’re comfortable with volatility, and they’re confident they can handle a 100% equity portfolio. But they haven’t really experienced volatility, and except for a short-lived downturn in 2011, they haven’t suffered a significant loss. A word of advice: your risk tolerance probably isn’t as high as you think.

Second, periods of low volatility provide a good opportunity to firm up your long-term investment strategy. The best time to make changes to your portfolio is when you’re feeling calm and rational. So if you’ve been procrastinating about dumping your high-cost active funds, investing that idle cash, or adjusting your asset allocation to keep it in line with your goals, then now might be a good time to do that. Because when this winning streak finally ends—and it will, though no one knows when—any changes you make are likely to be based on fear and emotion. And we all know how that works out, don’t we?

55 Responses to Do You Really Know Your Risk Tolerance?

  1. Brian G August 22, 2014 at 12:42 am #

    @RW, it looks like you’ve got a lot of opinions. Here’s mine… 🙂

    My “advice” (if you can call it that) is to create a new investment plan that you can live with no matter what happens in the market. Only you know what that is but here’s a few hints. You’ve said that you’re “risk tolerance isn’t what it used to be”. This would suggest to me that your target asset allocation of 80% equity/20% fixed income isn’t correct for you any more.

    You also seem worried that you are entering the market at a bad time. Would you have felt this way if you had stayed fully invested since May or would you be holding steady? It’s hard to internalize but like I’ve stated on here before: everyday, every investor makes a decision as to how to invest that day. For example, an investor that has stayed fully invested since May and decides to stay in the market on August 22, 2014 is making the exact same decision as an investor that is switching from cash to being fully invested on August 22, 2014. They are both taking their wealth and investing it on August 22, 2014. There really is no difference but it seems like there is!

    If you are speculating for only a few months then it may or may not be the case that the market has got too hot but nobody knows for sure either way. That’s why it’s called speculation. If however, you expect to be invested for a proper amount of time (e.g. 10 years or more for equities) then whatever happened in the last 3 months is likely inconsequential and that’s called investing.

    DCA in if that makes you sleep at night (which is a valid reason.) Only you know what is right for you. Create a plan that you can live with not knowing if the markets will go up 50% or drop 50% in the next year and each subsequent year… because those are the realities of equities. 🙂

  2. Tycho September 27, 2014 at 4:20 pm #

    I’m planning on taking an 8 month leave of absence from work beginning in January of 2015. To finance it I plan to use much of my TFSA, to help me meet an estimated budget of about $65k. As I’ve only recently begin educating myself on investing, I’ve had all that money sitting in a 1.25% savings account rather than invested. My research has brought me to index funds and the CCP specifically and I’m just about to move my whole $31k TFSA into the CCP recommended TD e-series funds, but I’m wondering if that maybe too risky since I do plan on using at least $20k of that, perhaps more depending on my how my saving proceeds over the next 14 months.

    I also have another $25k saved for this so far which I am also unsure what to do with since my TFSA is maxed. Is it worth investing this savings some how as well, or is it better to just to keep it in my 1.25% saving account?

  3. Canadian Couch Potato September 27, 2014 at 9:03 pm #

    @Tycho: If you plan on spending your TFSA money in the next year or so, then needs to be in cash. Both stocks and bonds can easily lose money over periods of even two or three years and should never be used for short-term investments. If your TFSA room is maxed and you have to keep $25K in a savings account, that’s fine. Even if you earn 1.25% on the whole amount that’s just $312.50 a year, and since it sounds like you’ll have no income next year you won’t be paying tax anyway.

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