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Sep 18, 2020

Staying the Course: Risk Capacity & Tolerance

Protect your capital from large swings in the market by sticking to a disciplined investment strategy and recognizing the risks associated with trying to time the market.

Linnea’s more than 20 years in the investment management industry has seen her work in a multitude of roles, including senior leadership experience in all areas of investment management including asset management, compliance, client management and sales.

As we move into the fall of an extraordinary year for the markets and global economies, many investors are surprised by how well portfolios have recovered since the COVID-19 market crisis peak in March. In this environment, it’s natural to wonder if it’s time to take some chips off the table and lock in some of those gains. Adding to investor apprehension, of course, is the upcoming U.S. presidential election and a possible change that will result in a fiscal policy shift. We cannot say for sure what will happen on November 3, and warn that placing a bet either way can be risky.

We don’t need to look back any further than the beginning of the COVID-19 pandemic to remind ourselves how difficult it is to time the market’s behavior. The rear view mirror tells us that we should have sold our equities in mid-February as the virus spread across the globe and economic lockdown followed. The question is how many of us would have jumped back in at the low on March 23? The time period between that peak and trough was record-breaking short. It’s near impossible for anyone to execute both of those trades perfectly. What we saw this year is not unlike any other market correction and recovery, however the speed of this one has been unprecedented.


S&P 500 Year-to-Date Returns

S&P 500 YTD Returns 

Source: Bloomberg

How do we protect ourselves from these large swings in the market? As unsettling as it seems, the best way to protect our capital is to stay the course and remain invested with a strategy that we can feel comfortable with through the highs in February and the trough in March. Now is a good time to review the importance of sticking to a disciplined investment strategy, and the risks associated with trying to time the market. When investors have a portfolio that’s too risky for their tolerance, they’ll feel compelled to sell at the wrong time; when the market is at a low. This will lock in their losses, and prevent them from participating in the recovery.

Successful investment strategies depend on your Client Portfolio Manager understanding your financial goals and your unique risk profile. Your Client Portfolio Manager will help you understand your capacity to take on risk, as well as your risk tolerance.

Your capacity to take on risk is more objective – it’s driven by your wealth and its ability to meet your financial goals. Risk tolerance is your emotional or psychological willingness to take on risk. The appropriate risk tolerance will provide you with a level of portfolio volatility that gives you peace of mind and allows you to sleep at night, even through the bumps of COVID-19.

Risk tolerance is different for every individual and it’s challenging to discern from a simple questionnaire. Realistically, it’s learned from a solid and transparent relationship with your Client Portfolio Manager and maybe even a good market correction. Having been in the business for a number of years, I often joke that you never really know a client’s risk tolerance until you have been through a 20% correction with them. I’ve also noticed that clients are much more risk tolerant and confident after the market has run up 20%.

Your capacity to take on risk can change over time depending on your financial situation and goals, however, your risk tolerance is more intrinsic and does not change radically over time. Your goals and risk profile help create your investment strategy, which then defines the asset mix that you invest in. Typically, your strategy should only be adjusted with major life changes (children, divorce, retirement) and usually incrementally over time. Any large upcoming needs for cash in the next one to two years (renovations, family vacations, purchase of vacation or rental properties) should be discussed with your Client Portfolio Manager so that appropriate reserves can be set aside for these goals. We won’t know until later if this is the best time to raise cash for these endeavors, but it will be protected if there is another pull back in the market.

If you make drastic moves to time economic and political events you’ll sometimes hit the jackpot, but other times you‘ll go bust. Our advice is to not gamble with your investment strategy as a wrong move can take years to recover from. Frequent reviews of your goals, feelings about portfolio volatility, and near-term cash needs with your Client Portfolio Manager are paramount to achieving your long-term investment goals.