How does your risk tolerance impact your investment success?

At the outset, let me say this: if you stayed invested in 2020, congratulations! You made history.

In 2020, the TSX experienced a record 39% difference between its lowest point of the year and its final closing value. This kind of market volatility can make a person feel like an inexperienced or like a well-seasoned investor all in a matter of one year

If you haven’t had a look yet, here’s the 2020 S&P/TSX data:

In client portfolios, our exposure to bonds, our strategic movements into and out of stocks (with our tactical models), and our quarterly dividend income paid, minimized our portfolio volatility and, by year end, most client portfolios posted positive returns.

Despite the full recovery of the market, the question I have been pondering is:

Did you stay invested during the lows of March 2020?

This question touches on individual risk tolerance. Let’s examine possible answers by comparing different types of travel and the risk tolerance involved in investing in stocks.

So here’s a simple mind experiment: First, imagine the future, when COVID-19 is no longer a threat and world citizens can travel freely and safely again. Now, imagine two travellers…

One heads out to visit friends in San Francisco, relax and catch up, maybe take in a Giants game. The other flies to Tahiti to surf the famous—and famously dangerous—Teahupo’o waves and stay in the five-star resort nearby.

Clearly, one travel plan contains more risk than the other.

It may also offer more reward: warm sun, beautiful beaches, luxury resort, stunning views.

Why are some people drawn to adventure travel while others prefer low-key leisure? Part of the answer lies in a person’s risk tolerance.

Some travellers would jump at the chance to run with the bulls at Pamplona while others would prefer to sit on a dock by a lake. Clearly, that first type has an extremely high risk tolerance.

A person’s risk tolerance influences their travel decisions—and their approach to investing in stocks.

Some investors are comfortable holding 100% of their portfolio in stocks and do not worry when the market declines, as it did in March 2020. Other investors are kept awake with even a small percentage of stock in their portfolios, and their fears drive them to sell during the first market drop they experience.

During the early years of my career, I was puzzled by the actions of those who panic during market declines, despite knowing that, historically, stocks perform well in the long term (over 10 years or more).

During every serious market decline I have witnessed, and there have been many (like the tech crash of 1999, the financial crisis of 2008, and of course the pandemic correction of 2020), a handful of clients have called and requested that all their investments be liquidated and placed in safe, guaranteed investments until the crisis ends. Usually, their market timing is terrible, and they sell at market bottoms or very close to it.

Why do investors sell when the market declines? I believe the answer lies in their risk tolerance.

Readers of this blog are aware that at Dri Financial Group, we ask existing and new clients to continually evaluate their risk tolerance when the market declines. Most investors end up somewhere in the middle of a low-to-high scale, with a moderate risk tolerance

Getting risk tolerance correct is so important, because we believe that investors will remain invested during market corrections if their asset allocation is appropriate for their risk tolerance.

For example, I ask clients to estimate how much of a market decline they would tolerate before anxiousness motivates them to sell their stocks. Let’s assume the client believes that they will sell if their portfolio declines by 20% or more. On a $1M portfolio, a 20% decline puts the value at $800,000.

I then ask the client to imagine how they would feel if they turned on their computer and learned that their portfolio was now worth $800,000. Would they panic and sell? Would they buy more stock? Or would they turn off their computers and stay the course?

If the client believes they would stay the course, I then assemble an asset allocation that minimizes the downside at -20%. I may suggest an asset allocation of 60% equities and 40% fixed income. Assuming stocks decline by 40% and bonds increase by 7% during a market decline, the expected return for a 60/40 allocation is approximately -21% for this client.

The objective is to build an asset allocation that maintains the downside risk within a client’s comfort level, hence reducing the possibility that they will sell during market corrections.

Another investor may place their comfort level at -10%. For this person, the fixed income component must be increased in order to reduce the volatility of stocks. Obviously, the opposite is true for investors with a comfort level of, say, -40%.

By now, the travel analogy is probably crystal clear.

Some investors are content in owning 100% equities, while others would prefer a 30% exposure. Some travellers want two swim with the sharks in Fiji. Others want to visit the Shedd Aquarium in Chicago.

The objective is to ensure that your actions are consistent with your risk tolerance, otherwise you will be an unhappy traveller and investor—one who sells during market corrections.

The simple lesson: identify your risk tolerance and set your asset allocation accordingly.

It’s also important to hold in mind that if you really are a Shedd Aquarium type, don’t waste any mental time on wishing you were the bull-running or shark-swimming type. Understand and be content with who you are—checking in periodically to see if you risk tolerance changes over time.

Also, if you have a low tolerance for market volatility, it’s not wise or profitable to have a large exposure to stocks. Minimize the stock exposure, increase your fixed income, and stop comparing your returns to the TSX or your friend’s investment portfolio.

Remember, a more aggressive portfolio would probably lead to many sleepless nights and may cause you to sell during market downturns.

Know your limitations. Know what you are and aren’t capable of doing or handling. Then decide: Do you want to paraglide in Nepal or tour the wine regions of France?

Never Retire Profile

Bob Dylan

The celebrated singer-songwriter has been in the news lately for having sold his entire catalogue—more than 600 songs over almost 60 years—to Universal Music for an estimated $300 million. As one of the best-selling music artists of all time, having sold more than 100 million records in his lifetime, Dylan continues to create and perform at age 79. His many awards include the Presidential Medal of Freedom, ten Grammys, a Golden Globe and an Academy Award. In 2016, he was also awarded the
Nobel Prize for Literature “for having created new poetic expressions within the great American song tradition.” A poster boy for the Never Retire philosophy, Dylan is known for having said, “A man is a success if he gets up in the morning and gets to bed at night, and in between he does what he wants to do.”

The process of finding a wealth advisor can be overwhelming. It is our job to make that process simpler and easier. Dri Financial Group’s proprietary Wealth Navigator Process is designed with you in mind. It’s structured framework helps you make an informed decision and feel confident in our team and management practices before we get started.

We offer you a range of services from creating bespoke financial plans and providing investment advice to helping you take advantage of our investment models. If you would like more information on the Wealth Navigator Process or our team, call me any time at 416.355.6370 or email me at richard.dri@scotiawealth.com.
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