What Did the Downturn Teach You About Risk?

When markets dropped earlier this year, it created something most investors don’t get very often: a real-world test of their risk tolerance.

It’s easy to say you can handle a 20% decline. It’s very different when your account is actually down that much. And the recent volatility driven by the war in the Middle East and fears of an AI bubble have given a lot of people their first real test in a while. Markets have calmed down considerably, but the downturn is very much recent enough to remember. Now that we are back near all-time highs as of this writing, I think it is an excellent time to assess your tolerance for investment risk.

A better way to think about this: when your account showed losses, what did you actually feel?

• Risk tolerance cannot be truly measured with a questionnaire when things are calm. It is far more useful to reflect on your mindset during this most recent downturn.
• Did you find yourself checking your account more than usual?
• Did you consider selling, moving to cash and “waiting it out”
• Did the downturn effect your sleep, mood or conversations at home and work?

If yes, now would be a good time to take stock of your portfolio and your willingness to handle risk. This is especially important because markets have had a great run in the past 3+ years and prices are elevated. Right now, the S&P 500 is trading at roughly 22 times forward earnings, which is high by historical standards¹. Also, concentration is at a high point. The five largest companies in the S&P 500 (Nvidia, Apple, Google, Microsoft and Amazon) make up close to 30% the index². It’s worth noting that this effects your even if you’ve never bought an individual tech stock. If you own an S&P 500 index fund or a target-date fund, a meaningful part of your portfolio is exposed to these stocks. To be clear, this does NOT mean the market is going to crash. Environments like this can, however, lead to lower returns moving forward and more volatility³.

For those nearing or in retirement, this is even more essential.

A 20% drawdown in your 30s or 40s is uncomfortable, but a 20% drawdown in the near the beginning of retirement can be much more damaging. Selling shares to cover expenses while prices are down means fewer shares are left to recover when the market eventually comes back. This is known as “sequence-of-returns risk,” and it’s one of the few retirement risks that genuinely cannot be undone after the fact⁴.

In a practical sense, this means that the same market move means different things at different life stages. The risk tolerance that served you well in your accumulation years may need to be revisited as you approach or enter your retirement years. The difference is that your portfolio is no longer just growing, it’s also providing you income.

Some practical steps you can take to set yourself up for success:

1. Look at your actual investment allocation. Portfolios drift as markets grow and if you haven’t rebalanced in a while, the mix you have today may not be the mix that was originally appropriate for you⁵.
2. Ask yourself a simple question: if your portfolio dropped 20% next year, how might your retirement plans be impacted? If you’re not sure, that’s worth figuring out now rather than during the next downturn.
3. Take the recent downturn seriously as data about yourself. Whatever you felt is important information, and it’s worth more than any questionnairer

Some perspective to conclude:

This years drawdown was by no means unique. Dealing with ups and downs is an unavoidable part of investing in the markets. When I describe “risk”, I am mostly talking about this volatility. The riskier your investments are, the more likely you are to experience swings in your portfolio balance. Occasionally, it’s useful to take a look at the risk you are taking and make sure it still makes sense for you. There is always going to be risk when investing and what I am talking about here is making sure that you are comfortable experiencing that amount of volatility and have a plan for when it inevitably comes. This is the essence of a long-term financial plan.

As always, I am here if you have any questions or would like to talk this through together.