Following is from my recent annual update to subscribers
The journey matters
I wrote about bitcoin in the 2017 update and compared it with small caps and midcaps. Since then bitcoin is down 75%, midcaps are down 16% and small caps are down around 30% on average.
A lot of investors believe they have a lot of tolerance for risk. I can tell you from personal experience, that most of us over-estimate our tolerance to risk, me included. There is a lot of difference between intellectually thinking of a 30% loss versus experiencing a real 30% loss in your portfolio.
For a check, think of how you felt during September when the market and individual portfolios dropped around 20%. These drops have gotten worse emotionally in the recent past due to social media and the speed with which rumors and panic spread. The same 20% drop causes far more anguish now than the past when such noise was minimal. In such a climate, it is critical to insulate yourself from the noise. If you don’t do that, it is likely you will panic at the bottom and make an irrational decision.
One way to insulate yourself from this noise is to know your own risk tolerance. If you think, you can bear a 30% loss on your portfolio – ensure that your equity allocation as percentage of your net worth does not exceed 50%. This will ensure that the net impact on your portfolio will not exceed 15%. In effect, ensure that the actual loss of your net worth is less than half your estimate of risk tolerance. This is a sort of margin of safety on your own behavior in case you have over-estimated your ability to withstand financial pain.
You will find a lot of charts on how companies like amazon have given 25%+ CAGR with 60-70% drops along the way. These charts show the 100X returns a hypothetical investor would have made in the last 15 years of holding this stock.
I can tell you that such hypothetical investors are very very rare and even if they hold this stock, it would be a small percentage of their portfolio. There is an infinitely small number of investors who can buy and hold such volatile companies as a large percentage of their portfolio. Try imagining your entire net worth going down by 80% and still holding on to it.
I am definitely not one of those brave investors. I have a much higher tolerance for volatility and risk than an average person, but I am not a risk savant - an outlier in terms of my tolerance. I have developed a level of risk tolerance over time but have always tried to remain within my limits. I see no reason for testing those limits as I don’t want to be miserable even if I get ‘richer’ over time.
There are no defined limits for risk tolerance. Every individual has to answer it for himself/herself. You will have to do same. One of the best test I have found is the sleep and worry test. If some positions or the overall equity allocation is causing you to worry and lose sleep, then it means that you are nearing your risk tolerance. At that point it makes sense to drop the position or reduce allocation before hitting the limit (and panicking at the wrong point).
I started worrying in late 2017 and hence reduced the equity allocation in the model portfolio. This allowed me to sleep better in 2018.----------------
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.