Like making the most of summer, sending your mum flowers on her birthday, or the consequences of a life spent overindulging on cake
how we handle a downturn in our portfolio is something we often dont think about until its too late.
Now, investing academics use the word volatility to describe these ups and downs in share prices.
They also use the word risk to describe the same thing, which I find pretty amusing.
Ive never met an investor who decided their shares were too risky because they were going up too fast!
On the contrary, outside of the Ivory Towers of academia, the risk is losing money.
And that only happens newsflash! when shares we own go down.
Investor, know thyself
You may think Im stating the bleedin obvious here, but an academic would probably take issue with me.
And in a way they have a point.
You see, too often investors think they can have it all that they can have their cake and eat it, and not ever suffer any metaphorical indigestion.
But shares dont work like that.
The whole reason shares have beaten cash and bonds over the long-term is because they go down as well as up, and most of us can only take so many downs.
This means that instead of owning only shares which over the long-term would be expected to deliver the highest return of all assets we spread our money between cash, bonds, property and so on.
In fact, if we really didnt care about the downs in our quest for the ups of investing, we might even only buy the riskiest shares in the stock market.
Typically these would be small-cap value-style shares, which as a class have smashed the returns from larger companies over the very long term.
But most of us do care about the downs. We can only take so much volatility before we feel queasy and small-caps can be very volatile indeed.
And so we spread our bets.
Crash test, dummy!
The trick is to get a sense for how much downside you can take well in advance of when youre tested.
That way you can aim to create a portfolio that wont see you needing to be talked off a ledge in a stock-market crash.
Thats the ideal. But in reality, people especially new investors tend toforget all this stuff in a bull market.
For example, I met private investors in 2011 with all their money in small cap oil and gas and mining shares.
After years of multi-bagging gains, they felt supremely confident just when they should have felt nervous!
More recently, weve had five years of a steady bull market in shares, despite plenty of terrible headlines along the way.
Everyone feels like a genius in a bull market. Nobody cares about the downside.
From the start of 2009 to the start of 2014:
- The FTSE 100 advanced 60%.
- The share price of microchip designer ARM Holdings (LSE: ARM) rose around 1,200%.
- Sports fashion behemoth Sports Direct (LSE: SPD) advancedover 2,100%.
- AIM-listed online fashion retailer ASOS (LSE: ASC) saw its share price rise some 2,400%.
These are hardly obscure little companies.
Yet their shares skyrocketed anything from 13- to 25-fold as we emerged from the financial crisis.
If that isnt volatility I dont know what is!
But is it risk?
I mean, it doesnt look like risk when shares are rising.
But its a different story when shares fall.
Since the start of 2014:
- Sports Direct is down 16%.
- ARM Holdings is down 21%.
- ASOS is down 67%.
In contrast the FTSE 100 has fallen just 4%.
This is volatility risk in action.
Of course, in the cold light of day most of us would say wed love to own a few 12-baggers such as ARM, even if it meant that sometimes wed see our shares fall 20% when times turned bad.
After all, even in the wake of that 67% fall this year, ASOS is still an eight-bagger compared to where it was at the start of 2009. Logic dictates its worth taking the rough with the smooth.
But you wouldnt know it from the anguished complaints on some bulletin boards, where Ive read some investors talk of throwing in the towel due to their losses in 2014.
Reading such sentiments doesnt tell you much about the long-term potential of shares.
But it does remind you about risk and our tolerance for it.
If the bout of choppiness that hitherto high-flying companies have experienced in the past six months has you looking for an early exit, it leads me to suspect you:
- Had too much money in shares
- Were over-invested in the most risky shares
- Didnt really understand what you owned
Or maybe all three!
How much can you take?
Figuring out your own risk tolerance is not easy, but it is definitely better done before youre caught out.
Theres certainly no one-size-fits-all approach.
If youre very risk averse you might put just 20% of your money in a tracker fund and keep the rest in cash, and sleep easily at night.
Most Fools are probably far more intrigued by the potential of individual shares than that, but theres still a vast spectrum between spreading your money across a basket of solid companies compared to betting all your money on a handful of stocks in a single exciting sector.
I dont even think theres necessarily anything automatically wrong with the latter if you truly know what you are doing and the huge gamble youre making.
No, whats important is to think about risk and how much money you could lose not when the market is already down, but rather when your portfolio is flying high and you cant help expecting even more gains.
Down but not out
Seeing your portfolio marked down 20% in a bad year will never be pleasant.
But if it means you cant sleep at night, you risk being turned off investing for life, or theres a chance that in a bear market youll sell all at the bottom and stuff your cash under a mattress then youve learned something important about your attitude towards risk.
That way the next time the sun is out and making money seems easy, youll hopefully think to take some off the table.
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Owain Bennallack has no position in any shares mentioned. The Motley Fool UK has recommended ARM Holdings. The Motley Fool UK owns shares of ASOS. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.