When you first visit a financial advisor, they’ll take you through a quiz to determine your attitude to risk. Based on your score, they’ll guide you towards a mix of investments that has the potential to help you achieve your goals, without giving you too many sleepless nights along the way.
This quiz has a fatal flaw: it relies on you knowing in advance what your attitude to risk is. And there’s no better occasion than the entire global economy seizing up overnight to find out just how wrong you were.
You can, of course, be wrong in the direction of taking on too little risk. That’s more of a creeping realisation over time, as you notice that your personal “finish line” never gets any closer.
But it’s realising that you’ve taken on too much risk that gives you the real stomach-dropping, prickly-skin, is-this-real feeling. And that’s a feeling a lot of investors will have experienced over the last few weeks.
What can you tolerate?
Here’s a real statement taken from a Standard Life risk assessment:
“Maximising long term investments is my goal, and I would be willing to accept dramatic, short term drops in value to achieve this”
It’s easy to tick the “strongly agree” box with bravado. But you have no idea how you’ll feel when that “dramatic, short term drop” happens until it actually happens.
It takes no bravery to recite Warren’s mantra about greed and fear when times are good, but how’s the quality of your sleep when there really is blood on the streets?
Building up your tolerance
Given that you have no idea how you’ll feel about watching a large proportion of your wealth evaporate, here are some practical and psychological tricks that should minimise the damage.
I don’t recommend you do all of these, or even necessarily any of them. They’re just ideas to get you thinking, and you might be able to take one and adapt it to your own needs.
Damp down your bravado by 20%
I would say by more than 20%, but until you’ve been through a crash you won’t believe it’s necessary.
So if you were going to go for 100% shares, go down to 80% and keep 20% in bonds, gold or similar. If you were going to put £100,000 into a risky investment, go down to £80,000 and keep the rest in cash.
In good times you’ll curse the drag this puts on your returns, but when it all goes wrong you’ll be grateful to have your landing somewhat cushioned.
Focus on real assets
If you own a property that produces an income of £5,000 per year, you’ll still have that £5,000 even if the value of the property falls by 30%.
Do you want that to happen? Of course not – and in reality, if the property market falls by that much there’s probably something else going on in the economy that will cause you other problems.
But in theory, your lifestyle isn’t affected by changes to the capital value because your income stays the same – and it’s easier to be sanguine about losing money on paper when there’s no threat of it affecting your lifestyle in reality.
Get interested in investing early in life
Or if this is reaching you too late and you’re not in possession of a time machine, do everything you can to get your kids / any young people you care about interested early in life.
Generally speaking, the economy will have a spasm at least every decade that will see asset prices plummet. If you start investing at age 20, you’ll live through the consequences of this before you’ve built up a serious asset base – so you’ll have a more accurate sense of your attitude to risk by the time you’re (hopefully) in a position to make larger investments in your 30s and beyond.
Keep a lot of cash on hand
Often, a downturn in investment values is related to events in the economy that will have you fearing for your main source of income too – so an emergency fund comes into its own. Even if not, it’s much easier to take a dispassionate, long-term view of your investments when your month-to-month quality of life isn’t in any doubt.
The other benefit of having cash is you can take advantage of price drops by buying in at the new, lower level – both making you feel better about the situation (an opportunity, not a loss) and planting the seeds for spectacular returns over the next cycle.
(Related reading: Holding “too much” cash can be a good thing.)
Just like damping down your bravado, holding cash will feel silly when everything is booming – but you’ll thank yourself later.