When talking about investing, risk is mostly analyzed in the following context: "how much is a given investor comfortable seeing their portfolio go down in a single year?". This is a reasonable question for us to ask ourselves when we are investing. Stocks, in the long run, have higher expected returns than bonds and cash. In order for us to capture these returns, we need to sit through periods where stocks do very poorly. This is the tradeoff. Stocks return more because they are riskier than bonds and cash.
If we misjudge our ability to tolerate fluctuations in our portfolio value, on the high end as well as the low end, we are likely to make big mistakes at the worst times. We will abandon our long-term investment plan when the portfolio experiences a sharp decline, or we will fail to rebalance and diversify away from an investment that is shooting the lights out.
So, in the short-term, understanding our risk tolerance matters a lot. You have to live with your portfolio day in and day out. You read the news and talk to your friends at work day in and day out. No matter how many times someone tells you "be patient", "no risk, no reward", "think long term", those things are pretty frustrating to hear when you're sitting through a 15-20% drawdown (kind of like what we had at the end of last year).
But, at the same time we have to balance our short term comfort against the big long-term risks. What are the big long-term risks? Not being able to retire when you want to. Not having enough money to last through your lifetime once you do decide to retire and start taking an income from your investments. Not having enough money to pay for your kids/grandkids tuition to university or college. This is a big risk, and it's often the silent risk in investing.
How many times will you turn on the TV or read the news online where you will hear or see someone forecasting the next market crash or next hot fund/stock? About every day, or many times a day, depending on how often you're checking. How often will you hear someone say "the big risk is loss of purchasing power in retirement"? Close to never.
So, what is the great challenge for long-term investors? To me, it's finding a balance between our short term risk tolerance and our long term goals, and building a portfolio that can fit both. We need to take enough risk that we give ourselves a chance, using reasonable assumptions about future returns, to meet our longterm goals; while at the same time being aware of our day to day/week to week ability to sit through periods where our portfolios aren't going to do well.
An advisor who knows your willingness, capacity, and ability to take risk can help you strike the right balance here.
The information in this material is not intended as investment, tax, or legal advice. Please consult your advisor or tax professionals.