“If no one ever took risks, Michelangelo would have painted the Sistine floor.” – Neil Simon
In July 2020, we wrote an article about investment risk for The Light. At that time, the world was in the early days of the COVID crisis: Many cities around the globe were under draconian lockdowns. The stock market had recently taken a beating due to the uncertainty surrounding the pandemic and, as a result, many investors felt that they had been taking too much risk with their investment portfolios.
Still now, in early 2022, the world is dealing with COVID and periodic lockdowns are happening in some parts of the world. But stock markets seem to have grown accustomed to life with the virus, and equity returns since the trough of the pandemic bear market have been impressive. The major US and global stock market indices finished 2021 at all-time highs, with the MSCI All Country World Index ending the year a shocking 76.6% higher than April 2020. Despite the correction in equity prices at the beginning of 2022, the bull market has eroded investors’ memories of the 2020 bear market, significantly changing attitudes toward investment risk.
Our 2020 article (inspired by the writings of David Hulstrom of Financial Architects) emphasized the three components of risk tolerance: risk capacity (the financial ability to afford risk), risk propensity (the psychological tendency to either seek or avoid risk), and risk perception (the ability to be aware of the risks at hand). Nearly two years later, now that we are in a very different market environment, you might feel that your risk tolerance has shifted, but it probably has not—or at least not by much.
Risk Capacity
If you weathered the bear market in early 2020 and hung on to your equities, you are likely wealthier now, meaning you can probably afford to take a bit more risk. But if you have not rebalanced your portfolio since 2020, you might unintentionally be taking more risk than you can afford.
For example, suppose your portfolio had a target allocation of 50% equities and 50% bonds at the beginning of April 2020. If you did not rebalance your portfolio back to the 50/50 target by selling some of those appreciated equities and buying bonds, the run-up in the equity markets would have shifted your allocation to nearly 64% equities by the end of 2021. In other words, if you have not rebalanced your portfolio, the increase in your actual risk may have already overshot the increase in your ability to take risk.
Risk Propensity
Risk propensity is a psychological tendency that varies widely based on recent personal history. After a period in which your investment risks are rewarded, as in 2021, you might feel that you are naturally disposed to be a risk taker and that you will be comfortable making a more aggressive allocation to risky assets. But thinking about risk in the abstract is very different from actually living through a bear market as your wealth vaporizes before your eyes. Although you might feel more comfortable with risk after seeing risky investments pay off in 2021, your long-term psychological disposition to risk probably has not changed at all.
Risk Perception
Risk perception is the trickiest aspect of risk tolerance because we tend to be less aware of risk after periods of relative calm. Consider the periods just before the dot-com crash, the global financial crisis of 2008, and the onset of the COVID crisis. In the 12 months before each of these catastrophic events, the average global equity return was 21.6%. In all three cases, the feeling at the time was that risks were subdued and there was smooth sailing ahead, but the truth was – and still is – that risk exists only in the unpredictable future and hides in imperceptible places. Although you might not perceive much risk in the current environment, it is indeed there.
Risk Tolerance In 2022
So, has your risk tolerance actually changed since 2020? If you invested with discipline and rode out the storm at the beginning of the COVID crisis, your risk capacity might be higher now. Your risk propensity probably has not changed, however, and if you are like most people, your risk perception has almost certainly decreased.
In times of exuberance, you might be tempted to give in to the fear of missing out and take on more risk. But when the next crisis comes along, the regret of losing money could lead you to reduce your risk at precisely the wrong moment. Your actual risk tolerance probably will not change much over time, so your best strategy is to stick with your long-term plan and maintain your risk level throughout the market’s ups and downs.