I want to start by separating some concepts that investors often use interchangeably: investment risk and risk tolerance. To me, the former primarily means two things.
The first is the possibility of permanently losing capital. The second is the possibility of failing to have enough money to retire comfortably. Interestingly, both taking excessive risk or too little risk can contribute to these outcomes.
Risk tolerance, on the other hand, is more about how much volatility you can psychologically withstand. How much can your portfolio fluctuate from day to day before you become uncomfortable enough to abandon your investment strategy?
Every dollar in your portfolio might represent hours of work after taxes, accumulated over years or even decades. When markets become volatile, you could watch the equivalent of a week’s, month’s, or even year’s salary disappear from your account balance.
Those losses might initially be unrealized, but they can become permanent if volatility pushes you into panic-selling. So how do you determine how much volatility you can actually handle?
Group of friends laughing on a roller coaster ride at the amusement park during sunny day.
Understanding standard deviation
For exchange-traded funds (ETFs), I generally prefer looking at standard deviation. This measures how widely an investment’s historical returns have fluctuated around their average.
Unlike beta, it doesn’t require comparing the investment against a particular market benchmark. For example, the iShares MSCI Canada ETF (NYSEMKT: EWC) has a three-year annualized standard deviation of approximately 13.7%.
Assuming returns followed a normal distribution, approximately 68% of annual returns would fall within one standard deviation of the average annual return. In EWC’s case, that means roughly 13.7% above or below its average. For instance, if the average annual return were hypothetically 8%, a one-standard-deviation range would extend from approximately -5.7% to 21.7%.
Importantly, that doesn’t mean EWC cannot lose more than 13.7% in a year. Market returns don’t perfectly follow a normal distribution, and unusually large losses occur more frequently than a simple statistical model might suggest. Standard deviation is useful for understanding historical volatility, but it cannot reliably predict how an investment will behave during the next crisis.
How much volatility can you personally handle?
While beta and standard deviation are useful, I think discussing risk tolerance entirely in percentages can be a little abstract. A more practical approach is to translate those percentages into actual dollar amounts.
Suppose you have a $100,000 investment portfolio. You might tell yourself that you’re comfortable with a 5% or even 10% decline. But what does that actually mean? A 5% decline represents $5,000. A 10% decline means watching $10,000 disappear.
Now imagine opening your brokerage account after a difficult trading session and seeing that your portfolio has fallen from $100,000 to $90,000. Would you remain comfortable holding your investments? Would you continue contributing? Or would you feel compelled to sell before things became worse? Answer these questions honestly.
The challenge is connecting your personal tolerance for dollar losses with the statistical characteristics of your investments. Standard deviation can help you make more informed estimates, but it’s inherently backward-looking. During a market crash, correlations can change, volatility can increase, and losses can exceed historical expectations.
If you discover that your actual tolerance for volatility is lower than expected, the simplest solution is often to reduce your equity allocation. You could keep a portion of your portfolio in cash through a high-interest savings account or invest in a short-term bond ETF holding high-quality government and investment-grade corporate debt.
The trade-off is that reducing volatility can also reduce your expected long-term returns. But if a more conservative allocation allows you to remain invested through difficult markets instead of panic-selling, I think that’s a worthwhile compromise.
Ultimately, the right portfolio is one that gives you a reasonable chance of achieving your financial goals while allowing you to sleep at night and stick with your investment strategy.
