Stock market volatility doesn’t imply direction of the stock market – it’s the price we pay for a higher return. Repeat this phrase to yourself whenever you feel anxiety overcoming logic and you’re tempted to sell your stocks into cash. After you calm down, take time to review your portfolio to determine whether it’s allocated in alignment with your risk tolerance and your need for return on investment (ROI).
To simplify the concept of risk tolerance, think of it as measuring how much volatility you can stand before you want to cash out. The riskier an investment is = the higher the return potential = the higher the volatility. “OK,” you say, “I can’t stand any volatility so I plan to sell all my stocks and transfer the proceeds to my savings account.”
Stop there. It’s not quite so easy. And repeat: “Stock market volatility doesn’t imply direction of the stock market – it’s the price we pay for a higher return.”
Return on Investment
Most of us invest because we want our money to grow. We want it to outpace inflation, to fund our key financial goals and to enable us to maintain our lifestyle in retirement. To understand how much ROI you need (and consequently how much volatility you will need to withstand) a few numbers are critical to know: How much you have now; how much you can add in the future; how much you will need in the future; and when you will need it.
If you are young and have many years ahead to save and invest, or if you have been a disciplined saver and investor, you may not need as high an ROI to reach your goals. If the volatility of the markets gets to you, you can rebalance into a lower-risk, lower-volatility portfolio. (This is accomplished by increasing your allocation to bonds or cash-like investments.) However, if you run the numbers and realize you have some catching up to do, seriously reconsider your desire to “run for the hills” and maintain an allocation to stocks.
When determining your risk tolerance and need for ROI, keep in mind that the stock market isn’t the place to invest money in stocks that you’ll need in the short term (in 3–5 years). For example, retirees would be wise to keep 3–5 years of living expenses in very safe investments. A prospective new homeowner wouldn’t want to invest their down payment in stocks. In addition, it’s just smart to maintain an emergency fund of six months to a year’s worth of living expenses in cash-like investments.
The charts and statistics below illustrate the long-term return potential of stocks, bonds and cash.