The problem with overestimating your tolerance for investment risk

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    New investors – especially when they are young – may be particularly susceptible to this mistake, but it is not solely their fault. The traditional advice is that young people should be aggressive. After all, time is on their side. It’s very unusual
    for stocks to generate negative returns over any 10 year period. If your time horizon is 50 or 60 years or more, why not?
    Invest 100% of your savings in stocks? There is some fairness in that argument, and if you really understand the implications of that decision, you will be building an all-equity portfolio. But I don’t think an inexperienced investor should do this. As a newbie, you’re like a fighter pilot who has only been in a flight simulator and has never flown in combat before. You really don’t know how you’re going to hold up until you’re battle tested.

    If you want to invest practically your entire portfolio in stocks, you need to be prepared that you could lose half your money – even if you hold broadly diversified index funds. In 2008-09 we had a 50% drop in about six months and it could happen again. Yes, if you are in your teenage or twenties you have the time horizon and the earning potential to make up for such a loss. But try telling this to a college student who worked three summers to make the $ 5,000 he just lost, or a young professional who just smacked a dozen paychecks.

    The danger is that investors who burn themselves badly at a young age will be forced out of the market for years – maybe forever. There is evidence that this happened to millennials, who were hit by the 2008-09 financial crisis and have lost confidence in stocks as long-term investments. It might have happened again after the crash of 2020 if the markets hadn’t recovered so quickly.

    If you are a new investor considering a very aggressive portfolio, there is one more problem you need to consider. If your account is still relatively small, your returns in US dollars won’t have much of an impact. For example, let’s say you start with $ 10,000. If you have a great year and make 10% in an all equity portfolio, you will make $ 1,000. Instead, if you make 4% with a balanced portfolio, you will make $ 400. In the long run, the difference between 10% and 4% returns is of course absolutely enormous. But right now, with a small portfolio, it’s a few hundred dollars a year, and that comes with all of the risks we just discussed. I am not sure if it is worth it. At this stage in your investment life, you are more likely to regret being overly aggressive than overly conservative.

    Here’s what I suggest to young people building their first ETF portfolio. Start with a balanced allocation – around 50% or 60% stocks are just the thing. Wet your feet for a couple of years and see how you react to the ups and downs of the market. Find out what type of investor you really are. Do you check your account balance daily and do you feel stressed when it is below its peak? When the markets wear off, do you instinctively sell or enjoy cheap buying?

    Restart your portfolio book cover

    The big test will come during the next bear market: if you lose 20% or 30% and it doesn’t worry you, you can be more aggressive with your portfolio going forward. Until then, focus on saving: this habit will have the greatest impact on your financial success.

    Dan Bortolotti, CFP, CIM, is Portfolio Manager at PWL Capital in Toronto. He works with clients to combine investment management with long-term financial planning. He also promotes investor education through his blog, article, and podcast.

    This article was read from Restart Your Portfolio: 9 Steps to Successfully Investing with ETFs.


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