Risk, Not Volatility, Is the Real Enemy
Grant us investors the wisdom to know the difference.
As the market has been dropping in recent days, what has been your strategy?
a. Add more money to my account.
b. Hold steady with what I’ve got.
c. Leave my money in, but be beside myself with worry.
d. Yank my money; I wouldn’t be able to stand any more losses.
Wait a second–don’t answer that. True, such questions are standard fare on risk-assessment questionnaires that you’ll find all over the web, and they have their roots in a well-meaning idea. If investors buy the right investments but sell them at the wrong times because they couldn’t handle the price fluctuations, they may have been better off avoiding those investments in the first place.
Most investors are poor judges of their own risk tolerance, feeling more risk-resilient when the market is sailing along and becoming more risk-averse after periods of sustained losses like the ones the market has been logging lately.
As investors, it’s helpful to create a mental distinction between volatility and risk. Volatility usually refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period–a day, a month, a year. Such fluctuations are inevitable once you venture beyond certificates of deposit, money market funds, or your passbook savings account.
Definition of risk, by contrast, is the chance that you won’t be able to meet your financial goals and obligations or that you’ll have to recalibrate your goals because your investment kitty come up short.
Volatility: Noise on the evening news, and maybe a frosty cocktail on the night the market drops 300 points.
Risk: Having to move in with your kids because you don’t have enough money to live on your own.
Diversify your portfolio among different asset classes and investment styles. This can also go a long way toward muting the volatility of an investment that’s volatile on a stand-alone basis.
Also give some thought to what’s an appropriate stock/bond/cash mix for your goals/risks.
Finally, plan to keep money you need for near-term expenses out of the volatility mix altogether. One strategy would be creating separate “buckets” of a portfolio and in particular, a bucket for any cash the investor expects to need within the next couple of years.
original article by Christine Benz w/ Morningstar