When it comes to investing, we should not only recognize that we have comfort zones, we should learn from them to refine our strategy and goals. As Yogi Berra said, “If you don’t know where you are going, you might not get there.”
What is your investing comfort zone? Figuring this out requires examining how you react to volatility in the stock and bond markets. Did a recent setback cause you to panic?
We shouldn’t let anyone tell us how to react to market volatility – we should respect our own reaction and learn from it.
It only takes a few minutes, but it’s a great idea to write down your long-term and then short-term investing goals. (Reaching the short-term ones leads us to achieve the longer-term ones.) Long-term goals can include reaching a particular amount for our retirement nest egg, or simply increasing our total net-worth. Short-term goals can include rebalancing, buying or selling a particular stock, or setting aside funds for a major purchase.
Comfort zones for long-term investing
The challenge in defining our comfort zone (risk tolerance) over the long term is that two conflicting emotions are at play:
- a) wanting to benefit from the long-term rise in the stock market and,
- b) wanting protection from market corrections along the way.
We have been told to hang on during market setbacks to avoid selling low but, emotionally, this has proven very hard to actually do.
Setting our asset allocation, (percentages in bonds/stocks), is the best way to ensure that we stay within our investing comfort zone. Once we set our asset allocation (i.e., 25% bonds, 75% stocks), we have a path to handling market volatility. If our stock portfolio has dropped, then when it’s time to rebalance, we simply sell some bonds and buy enough stocks to get back to 25/75. This discipline forces us to sell high and buy low—the ideal strategy.
If the goal is to maximize our nest egg, or to increase our net worth, the best way to do that, in my opinion, is to invest in index funds. In our example, I would buy a set of diversified equity exchange-traded index funds to make up 75% of my portfolio, and index bond funds to make up the remaining 25%. We have all heard that index investing outperforms active investing over the longer term, after accounting for investing fees. Why does this happen? The index is always going to capture the winning stocks—by definition. Rising stocks come in at low valuations and gain market share in the index as their price rises. Losing stocks gradually slide down and get dropped from the index. Index exchange-traded funds include 250 stocks in the case of the TSX, and 500 in the case of the S&P. An individual investor would not be able to come close to this degree of diversification by holding individual stocks, and would be extremely unlikely to be able to pick out the winning stocks from that large a sample.
What does a very wide comfort zone look like?
Let’s say I am very comfortable taking large risks with a small part of my overall portfolio in the short term. Many investors (including me, for the record) have invested in pot-stocks to make a quick profit. Before buying, I would set a target selling price that I would like to reach, and a stop-loss price at which I think the investment should be sold (at a loss) to avoid losing all of the initial investment. Let’s say I want to make a 100% gain (a doubling of the stock price). If so, I would stick to the plan and sell the stock once it reaches that price. It is very tempting (trust me on this one) to hang on and try and get more out of the stock once it gets to that target, but it’s important to stick with my goals. If my stop-loss price is a drop of 50%, then I just hang on for the ride for any drop of less than that and hope that the price subsequently rises. In recent months, I can tell you that stocks going up or down 10% in a day is not unusual. This very wide comfort zone is not for everyone!
What does a narrow comfort zone look like?
A very different short-term goal is a down payment on a cottage. Let’s say I have $60,000 invested in exchange-traded funds in my TFSA and I have recently decided to buy a cottage in two years. Knowing that I need the funds in exactly two years and that I don’t want to risk losing any of this down payment, I get ready to sell my long-term investments (on a small upturn in the market, hopefully) and move my money into a Guaranteed Income Certificate (GIC). I can be confident that I will earn about 3 per cent per year at current rates and that my principal is safe. Clearly, this is a zero-risk approach – no sleep lost on this one!
We can be inundated by advice on how to invest, but the most important advice is to trust in our own comfort zone. If we are worrying day-to-day about our investments, we have one of two problems:
- We don’t understand that long-term investing involves short-term volatility; or
- We need to re-evaluate how we are investing so that we take on less risk.
Either way, the immediate short-term goal is to learn enough about investing to figure out our ideal comfort zone and get there as soon as possible.
Let’s remember that we invest to make our future more comfortable. With a bit of effort, we can make our journey more comfortable as well.