Risk Happens
As featured in the June/July issue of the Winchester Resident Magazine
Airline cabin crew can tell passengers what to do in the event of the aircraft "landing on water", but I wonder how many of the passengers would remember unaided how to fasten their lifejackets if they were forced to endure the real thing.
Financial advisers can ask clients how they would behave in a stock market crash, but the recent falls will likewise have tested those discussions held in calmer days.
It's an important opportunity to candidly explore your emotional investment risk tolerance. If you feel like cutting your losses and selling your equity investments, it's probably a strong indication that you may have been overexposed to equities before the crisis happened.
We have seen a variety of reactions to the losses in recent weeks. Some have said "maybe I should reduce my exposure to the stock markets" (although the falls have already done some of that!). Others are just sitting tight and waiting for things to improve eventually and some are seeing now as a buying opportunity to put more into their equity investments.
These reactions usually reflect differences in what we call “emotional risk tolerance“.
Budgeting Investment Risk
Your emotional risk tolerance is only one of three factors that should determine how much you invest in risky investments such as shares.
The second factor is the rate of return that you require from your investments to meet your financial objectives and support your lifestyle. The higher the rate of investment return you need, the more investment risk you will have to accept, because risk and return are related.
Thirdly, there is your capacity to suffer financial loss. For example, if you lost 20% of your investment portfolio, is this likely to mean that you are going to have to reduce your lifestyle as a result? Of course, even if the answer is yes, some people are more relaxed about this than others who may insist on their annual Caribbean holiday as a human right.
We all feel an emotional, sometimes gut-wrenching reaction to stock market losses, but it's very important, at that most difficult moment, to keep a cool head. You should review, from the new starting point, what your required investment return is going forward (and therefore the investment risk exposure to equities you need) and also what would happen if there is yet another investment shock further down the road, before committing yourself to any changes in your strategy.
Proper financial planning can put the numbers on this to give you the answers to questions 2 and 3, but then hopefully those answers are also no more than the investment risk you would be emotionally and psychologically comfortable to take going forward.
Having done that, you should then have the peace of mind to accept that you've looked at all the issues and you've made a reasonable judgement going forward, and you've at least done what you can.
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