Your Tolerance For Volatility

There’s an old investing tale, often attributed to a study from Fidelity investments, claiming the best-performing accounts belonged to people who either forgot they had an account or were dead. Fidelity has never acknowledged the study, but the lesson is important.

John Rekenthaler at Morningstar wrote about the lesson ten years ago (link here). If you’d rather not read Mr. Rekenthaler’s piece in full, the lesson is best articulated by this Warren Buffett one-liner:

The stock market is a device for transferring money from the impatient to the patient.

You can’t be more patient than a dead person.

What drives patience versus impatience in investing? The usual culprits: fear and fear of missing out.

In our advisory role, not counting an estate account or two, we deal with the living. As a result, we have to establish how much volatility you can handle in your investment accounts.

How do we do it? It’s multifaceted but let me start with the most important consideration: time.

Money needed in less than three years (some advisors say five) should not be allocated to investments. Period. Keep those funds in high-interest savings vehicles or GICs, or other things that can’t decrease in value. Loss aversion is real (losing hurts twice as much as winning).

Long-term money, like your retirement assets, should be invested. And that’s because we know your time horizon should smooth out expected market volatility.

But how much volatility can you (or should you) handle?

Assuming you’re appropriately diversified, more volatility means a greater expected return. It’s called a risk premium for a reason.

It sounds good in theory, but some investors just can’t handle volatility, whether they know it or not. How do they find out?

There’s the most beloved Risk Tolerance Questionnaire (I hope you caught that sarcasm) that must be completed before opening any investment account in Canada. The robo-advisor platforms have you fill one out and so do we real life advisors. A lot of advisors address all the risk questions in their usual discovery meeting through regular conversation. They do this to avoid the awkwardness of completing an impersonal, flawed document.

The document is flawed for straightforward reasons: they measure how you feel before you invest and experience volatility; they measure mood instead of behaviour; and they don’t tell you (or me) a single thing about how you will actually react when your investments get hammered.

Here’s where we are so far: time is the most important consideration, and the RTQ is flawed and doesn’t really tell us what we need to know. So what do we do?

We separate your ability to take risk from your willingness to take risk.* Ability is objective: time horizon, spending flexibility, liquidity needs, and math. Willingness is emotional: how you feel and behave when your portfolio drops.

We can figure out your ability through regular conversation. Your willingness, though? That’s more art than science.

Your willingness to take risk has to do with you. And I don’t mean you in a judgmental way. I mean you in the sense that every investor, myself included, uniquely reacts to volatility. No two people experience discomfort the same way. The reason I write so many posts about market volatility is to help with the discomfort.

What do we do as advisors? We listen for clues when we speak with you. Not to catch you, but to understand what volatility means to you. The goal isn’t to make you more aggressive or more conservative (though I prefer most clients invest in equities/stocks). The goal is to build a portfolio you can live with.

Here are some of the things we look for:

• How you talk about past downturns. Are they temporary setbacks or permanent losses?
• If you compare your performance to others. Comparisons are normal, but they can drive emotional decision-making (this is yet another reason I suggest my clients own “the market”).
• How often you check your accounts.
• Your spending flexibility. Someone who can tighten spending temporarily will experience volatility differently from someone who can’t.
• Whether you’ve lived through a major decline before. Experience is a beautiful and painful thing.
• How anchored you are to previous highs. This one alerts me the most because some investors see a pullback from a peak as “losing money,” even when they’re still up over time.
• Whether headlines shake your confidence.
• Whether bad markets feel dangerous or simply uncomfortable. There’s a big difference.
• How much you trust the long-term plan. The best portfolio won’t survive a crisis of confidence.

None of these are right or wrong. They’re just clues. They help us understand what feels tolerable in theory and what feels tolerable in real life. Everyone feels brave in calm markets. It’s only when things get ugly that investors discover their true tolerance for volatility.

Our job isn’t to judge your comfort level. Our job is to align your portfolio with it and to educate you. A perfectly optimized portfolio is useless if you can’t stay invested through the worst. And believe me, our job and our goal is to keep you invested through the worst.

*With thanks to the CFA Institute. This content was covered in the Level III Exam. See? I didn’t just cram and pass exams