It's hard to control our emotions as investors.
Most, if not all, investors have watched the stock market pull back substantially, and reacted poorly as a result. Maybe your reactions have been mild, like worrying that you should have sold a stock when it was at its recent high. Or maybe you've absolutely panicked, and wanted to sell everything you own.
Having a negative reaction to market volatility is completely normal. How you respond, however, can determine how successful you become as an investor.
During my years as a financial advisor, I came to learn that how well a client did was often correlated with the level of risk they were taking -- and more importantly, how comfortable they felt about that level of risk.
Investors who had portfolios that were in line with their appetites for risk fared better than investors that didn't for these 3 reasons.
1. It leads to a smoother long-term investment plan
When building a financial plan, it's a good idea to have an end goal in mind and a roadmap to how you will get there. How you're invested is instrumental in how bumpy that road could be.
Take, for instance, a recent bear market. During the 2008 stock market crash, a portfolio that was 100% invested in large cap stocks would've lost 37% of its value. Assuming you had $100,000 invested, your nest egg would've shrunk to $63,000. You wouldn't have returned into a positive investment territory until 2012.
Conversely, if you had $100,000 invested in a portfolio made up of 60% stocks and 40% bonds, your investments would have only shrunk to $77,600. Your portfolio would have returned to positive territory in 2010.
Of course, in exchange for a smoother investment ride, there are sacrifices that you make. Over a 10 year period, if you owned the large-cap stock portfolio, you would have ended up with just over $216,000. The stock-bond portfolio would have ended up with about $167,500.
When looking at the numbers, your natural inclination may be to choose the portfolio that has the highest overall return. That overall return is meaningless though, unless you stay invested for the entire 10 year period. Time in the market is extremely important -- so when exploring your risk tolerance, you must be mindful of what matters most to you. As great as a higher investment portfolio will be, will fewer fluctuations up and down enable you to stay in the markets until you reach your goals?
2. It takes some of the scariness of investing away
Everyone loves making money, but investing doesn't feel so great when you're losing money. Losing money leads to uncertainty around your financial stability -- which is what can make it scary.
Unfortunately, there is no way to completely eliminate this uncertainty. Instead, you can learn how to manage it.
Get comfortable with what your worst-case investing scenario might be. For example, large-cap stocks lost 37% in their worst year so far in history. Corporate bonds lost 2.76% in their worst year. With this type of historical knowledge, you can compile blended portfolios of different asset classes to see projections of the worst year and best year. From there, you can pick the one that balances your goals and financial stability needs.
That said, you can't control what the markets are going to do and when. You can, however, be better educated around what that could mean for your personal accounts. This way, when you do experience a scary drop, you're better able to cope.
3. It helps prevent realizing losses
If you hold a stock or portfolio that is too risky for you, it may make it harder to ride out inevitable storms. The unintended consequence ends up being selling a stock for less than what it was purchased for and realizing a loss -- and that's one of the fastest ways to fail in your investment goals.
Between January 1, 1999, and December 31, 2018, the S&P 500 earned an annualized return of 5.6%, while the average investor earned a return of just 1.9%. This difference in return partly happens because of bad market timing and investment decisions being driven by emotions.
No matter how good the potential for a stock may be, if it doesn't align with your risk profile, it's not a great stock for you. In order to determine what type of investments are too risky for you, you should first consider your honest reaction to stock market volatility.
Are you someone that sees opportunities when a market pullback happens or have you been tempted to sell (or actually sold) your investments? In the past, have you seen your investments suffer because you often buy them at higher prices when everything is going well but sell them at a loss out of panic? What's your overall temperament for taking risks?
Look for risk tolerance quizzes or assessments that take all relevant factors into account (including your age and liquidity needs) to help you to better understand how much risk works for you.