Risk Tolerance and Time Horizon
Risk tolerance and time horizon are two factors that help determine your investing strategy and asset allocation. Both items are impacted by your age (young adult, family formation, retirement) and life events (marriage, children, retirement).
Risk tolerance relates to how much market volatility you are willing to accept, how you are able to stomach your portfolio going up and down and how much variability in returns you are willing to accept. Risk tolerance can be impacted by the expected return, how you feel today and your past experiences. Risk tolerance has a significant impact on the composition of your portfolio (stocks, bonds, cash) and whether you will invest conservatively or aggressively (the higher the risk the higher the return) or somewhere in between.
Terms You Should Know
Before we take a look at the numbers, lets review some of the terms you hear when listening to the news about the “stock market”.
Stock Market Indices
There are a number of indexes which help to determine the movement of the “stock market”. The most well known index is the Dow Jones Industrial Average (DJIA). DJIA is a price-weighted measurement stock market index of 30 prominent large capitalization companies listed on the stock exchanges. Although one of the oldest and well followed index, some say it is not a good representation of the broader stock market which exists today. Other indexes which represent a broad market of stocks are the Standard and Poor’s 500 (S&P 500) and the Russell 2000.
The S&P 500 index tracks 500 publicly traded domestic companies. The index computes a weighted average of the 500 stocks included in the index, therefore the stocks with a larger market valuation have a greater impact on the index. The Russell 2000 index is comprised of 2,000 companies with smaller market capitalization than the DJIA and the S&P 500.
The last major index is the Nasdaq Composite which includes almost all stocks listed on the Nasdaq stock exchange. The index, like the exchange, is heavily weighted to the information technology sector.
Other Terms to Know
Although the following terms are used in a variety of ways, these are the technical definitions:
Perhaps the most common definition of a bull market is a situation in which stock prices rise by 20%, usually after a drop of 20% and before a second 20% decline. On the other hand, a bear market occurs in situations in which stock prices fall by 20% or more over a sustained period of time, typically 2 months or more. A correction is a 10% drop in stock prices from their most recent high.
Risk Tolerance and Annual Returns
The stock market return as measured using the S&P 500 for the last 5, 10, 20 and 30 years was:
| Period | Average Stock Market Return | Average Stock Market Return, adjusted for inflation |
|---|---|---|
| 5 years (2016-2020) | 15.27% | 13.06% |
| 10 years (2011-2020) | 13.95% | 11.95% |
| 20 years (2001-2020) | 7.45% | 5.3% |
| 30 years (1991-2020) | 10.72% | 8.29% |
Overall, the stock market return on average is 10% annually in the United States, 6-7% after inflation.
However, there have been significant intra-year declines. That is, the years have been quite choppy with ups and downs.
As you can see in the last 42 years, based upon the S&P 500, there have been 35 up years and 7 down years. However, in each of those up years there have been intra-year declines. In 3 of those years the declines have been in excess of 20%; in 11 of those years the declines have been between 10% and 20%; and in 21 of those years the declines have been single digit. Of the 7 down years, 4 of those years had declines which were less than 10% and the remaining 3 years had declines of 12%, 22% and 37%. All 7 down years had significant intra-year declines.
This graph tells me several things. First, the stock market is highly volatile. Second, to capitalize on the market returns you need to be invested in the market during the move to the upside and the downside; you cannot time the market. Third, if you enter the market during a down market and the market continues downward it might take years to recoup your original investment. Finally, the market can test your commitment to your investment strategy and your asset allocation. However, annual returns should not be your only focus when determining your investment strategy. You must also consider your risk tolerance and time horizon. You must work diligently to fully understand and determine your risk tolerance.
Determine Your Investment Strategy and Risk Tolerance
Your investing strategy should be developed while reviewing your personal profile. One tool to assist in that process is the Charles Schwab Investor Profile Questionnaire. The quiz measures two factors, your time horizon and your risk tolerance. Complete the quiz and determine how your risk tolerance impacts your investment strategy. If you are uncertain of how to establish your investment strategy, contact an investment manager.
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