Remember, you are only a man.
This ancient reminder served as a humbling gesture intended to keep the victorious leader grounded and aware of the fleeting nature of their achievements and power. With the financial markets nearly recouping their losses stemming from a horrendous year in 2022, investors seemingly forget the fundamental principles of “Memento Homo” concerning the unpredictable and impermanent nature of the markets. The pendulum has swung from extreme despair to extreme optimism. There will be more corrections to come, just like there will be more booms to come. Remain humble.
As investors, we can study standard deviations and risk. We can model drawdowns and market corrections. Our flaw, however, is that as humans when we visualize stock market losses, we imagine ourselves in some hypothetical world where the only thing that has changed for the worse is the stock market. But stock market drawdowns do not exist in a vacuum. What we cannot visualize is the state of the world that causes that stock market downturn and how it feels to live through moments where the headlines are filled with World War III jargon, pandemics, inflation, and civil unrest. It’s these emotions, and their control (or lack-there-of) that can lead us down the path of continued wealth creation or sudden destruction.
As we move further into the year and unrealized losses have generally been recovered, we encourage you to revisit your risk tolerance. Like I’ve written about previously, to assess our own risk tolerances, we must consider our willingness and ability to withstand, as well as our need to take on, risk.
Willingness is all about a gut feeling of comfort. It is a non-quantitative concept. A common test for willingness to take risk is the “sleep at night test.” If you can’t sleep at night because of an investment decision, then you may have exceeded (or are considering exceeding) your willingness to take risk. J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, “What should I do about my stocks?” Morgan replied, “Sell down to your sleeping point.” Conversely, if your decisions do not cause you unrest, your investments are probably aligned with your willingness for risk. Thus, willingness to take risk reflects your level of comfort with possible loss. If the markets made you feel sick in 2022, you are probably taking too much risk.
While your willingness for risk may come from an innate feel in your gut, your ability to take risk is quantifiable.
It is based on your financial plan or budget. To be able to take on risk you must have something you can afford to place at risk. Thus, your ability for risk is your investable surplus above and beyond what I’ll call your operating cash flow. In other words, how much can you afford to lose while still maintaining your standard of living or saving towards a future goal? If you need every single dollar within your portfolio to sustain your lifestyle as you move deeper and deeper into retirement, you may want to consider recalibrating the portfolio for principal protection instead of growth as an example.
Finally, similar to ability, your need for risk is quantifiable. This is the amount of risk that the investor needs to accept to reach his or her financial goals. The rate of return necessary to reach these goals can be estimated by examining time frames and income requirements. Then, the rate of return information can be used to help the investor decide upon the types of investments to engage in and the level of risk to take on.
It takes guts to be an optimist.
Progress compounds slowly and to such an extent that we often barely notice it. Setbacks can be sharp and terrifying, yet somehow, we usually rebuild and the compounding of progress continues. With the stock market rallying, the harsh realities of 2022 seem like a distant memory, and while it may be tempting to invest your emergency funds in stocks, please don’t. Investing comes down to surviving an inevitable chain of short-term setbacks to enjoy long-term progress and compounding. Live your life like an optimist, but never lose that healthy dose of fear.