In the past three years, investors in the TSX have experienced a 37% drop over a one-month span, a subsequent 109% gain over two years, then a 16% decline over three months, to then see a 10% gain in the past few weeks. These are pretty big swings, some of them blindly fast. And in 2022, we have inflation returning as a top issue, eroding how much we can buy, coupled with rising recession fears. Plus, prices across asset classes and markets are moving more in tandem than usual, reducing diversification benefits. So, we cannot imagine a more fertile backdrop to think about risk.
Don’t worry, we are not going down the math road of talking standard deviation, semi variance or various moments [but if you want to ring us, we do like talking math]. The math is all about trying to quantify volatility, but risk incorporates so much more than how much an investment may go up or down. In fact, risk is more so in the eye of the beholder, the investor.
With the core foundation that taking on higher risk increases the return expectation (clearly not with certainty) or lower risk has lower return expectations with greater price stability (again, not with certainty), all investors sit somewhere on this spectrum. The inputs regarding where you might sit range from time horizon, wealth, cash flow, investment acumen . . . the list is long. But sometimes an investor’s capacity for risk is different than their tolerance.
Tolerance vs capacity
Capacity is a function of the size of the nest egg or portfolio, contributions, and the requirements from the portfolio. For instance, if a portfolio has a sizeable cushion (aka, it’s a large portfolio based on planned defunding requirements), the risk capacity is higher. Or if an investor still has many years of portfolio contributions ahead based on their savings and income, again, the risk capacity is high. Alternatively, investors who have retired and lack a decent safety cushion have less capacity to take on risk since adverse changes in the market to the portfolio's value could jeopardize the portfolio's objectives. Capacity has much more to do with financial planning and can be quantified with a good plan.
On the other hand, risk tolerance is a function of the investor’s behaviour. Low tolerance for risk increases the risk of making a behavioural mistake, such as bailing from investments during downturns and causing damage to the long-term return potential of the portfolio. Usually for investors with lower risk tolerance, a less volatile portfolio is used. High-risk tolerance, especially when markets are moving higher, eliciting the fear of missing out, can lead to performance chasing. And very importantly, risk tolerance can change substantially with the markets. It is important to understand if you have a highly variable risk tolerance.
Perhaps the easiest way to see changing risk tolerance is to look at performance chasing. Investors had no problem piling into bonds when the prices were high and yields low. Bonds had performed well, and money piled in when yields were next to nothing. Conversely, equity investors felt more comfortable adding money to equities when the S&P is above 4,000 but take money out when much lower. The more the price of something goes up, the higher people's risk tolerance appears to become. Conversely, the lower the price, the higher the perceived risk. So backward.
Note – There are times when tolerance is different than capacity, which can be a dangerous combination. It can lead to taking on too much risk given capacity, often in rising markets. It can result in a divergence from the longer-term financial plan. And since risk tolerance can change, often with the markets, a disconnect can arise quickly. Reverting back to focus on the long-term plan can be a useful framework to reduce this risk.
2022 is a great year . . . to think about risk
The vast majority of portfolios are down so far this year, so it might not be a great year from a performance perspective, but given the number of twists and turns, it is a good year to get to know your risk levels.
The 1st half bear – TSX fell 18%, S&P dropped 24%, and Canadian bonds were off by 14% by mid-June. Both bonds and equities are down, clearly not kind for most portfolios. And there were some harrowing single-day drops of 3-4%. So, how close during the first half of 2022 did you come to changing your asset mix? That real-life experience likely tells you much more about your risk tolerance than any questionnaire or hypothetical scenario. And it likely told you something about your risk of making a portfolio mistake.
- Those who bought or thought about buying to add market exposure – clearly have a higher tolerance for risk and contrarian behaviour, which is a good investor characteristic.
- Those who thought about selling or sold to reduce market risk - this likely captures the majority, at least based on market fund/ETF flows, and demonstrates a lower risk tolerance or at least a risk tolerance that is more sensitive to market gyrations. Knowing helps.
Bounce off the bottom – Markets have partially recovered over the past couple of months. Even many of the speculative investments that flew the highest in 2021 and fell the most in the first half of 2022 have risen the most during this ‘bounce.’
- Has this bounce elicited strong feelings of missing out? This would certainly demonstrate a highly variable risk tolerance/appetite.
Please note we are not saying making tactical portfolio changes is wrong when markets are volatile. Far from it. But the changes should be based on a process, like a change supported by a well-researched basis. The goal is to try and avoid making portfolio changes based on your personal changing tolerance or appetite for risk. Those are most often the wrong decisions.
Inflation risk – This is a risk that remained dormant for decades and is certainly back. Looking past the current elevated headline numbers and the near-term path, the big risk is inflation comes back down but settles at a higher level. Say, 3-4% instead of 1-2%. What does that do to your financial plan or capacity for risk?
It may prove useful to update or scenario test a longer-term financial plan by inputting a higher inflation rate. And if that uncovers a great risk, save more or nudge the portfolio a bit more towards investments that can handle inflation better.
2022 – A year more prone to mistakes
With the big market moves, both up and down, 2022 is a year many investors have a higher risk of making a portfolio mistake. And it isn’t over. Below we have outlined a few guidelines that may help in the journey:
Create a plan – To understand your capacity for risk and to help tether your risk tolerance when it strays, a long-term plan really helps. It enables you to look past near-term gyrations and focus on the longer-term goal.
Get a 2nd opinion – We are all emotional, and when the value of our money is changing quickly, emotions often run higher than normal. This is the time you are most at risk of making a mistake. Getting a second opinion really helps, even though they, too, are emotional. Think of it like diversifying your emotions with theirs to help avoid an emotionally driven portfolio decision. During these times, the value of advice often shines brightest.
Take a break – Sleep on it. Often your subconscious will process more information and lead to a better decision. Plus, if you take a break or go for a run or bike ride, emotions calm down.
Be wary of performance chasing – Most believe performance chasing happens only in up markets. Not true. The first half of 2022 has been very unique – similar to 1994. The risk now is that investors are lured into strategies that worked well in the first half but have not worked well in previous years. For instance, CTAs did very well in the first half, certainly worth considering but don’t load up on what worked in this unique market environment. It may be a long wait for a repeat of 1H 2022.
Understanding yourself and how you react (or want to react) to market moves up or down can help you become a better investor. Institute steps to be taken to help manage behaviours when emotions are elevated. The truth is great investors often don’t have a crystal ball; they simply make fewer mistakes than others.
Know thyself – Socrates
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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Sources: Charts are sourced to Bloomberg L.P.
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