Plan for Volatility and Risk

Volatility vs. Risk

Risk is a concept that is closely related to, but subtly distinct from, volatility. Volatility essentially means that every day is a little bit of a roller coaster. We don’t know what’s going to happen. We don’t know what’s going to happen with regard to pandemics, with wars, with interest rates, with big businesses crashing, or how those changes will affect us. There can be a war going on that will impact food and fuel and cause costs to dramatically increase. There can be a pandemic that can shut down restaurants for months. We have no idea year by year, or even month by month, what might happen next. Risk refers to the very real risk that you might suffer losses that you don’t recover from.

Given the reality that volatility is a fact of life, an inescapable fact of life, your job is to make decisions about the level of risk that you want to take on in your investments in your portfolio.

Risk Profile

Each person will have a given risk profile, and that risk profile will be conservative, moderate, or aggressive. It will lay along a spectrum.

A conservative risk profile means that you are building a portfolio that is relatively predictable. Nobody has a crystal ball, but if assets in the future perform as they historically have in the past, then a conservative portfolio means that there’s going to be less volatility (and there’s probably less upward potential), but you have a more predictable set of outcomes. And so a conservative portfolio might be comprised of a heavy allocation in bonds. It might be comprised of large-cap stocks or large-cap index funds, some relatively stable blue-chip companies. It may be comprised of rental properties that are paid off free and clear.

Moving all the way over to the more aggressive side of the portfolio, you may be taking on some exposure to commodities like oil, corn, wheat, or gold. You may be taking on exposure to real estate investment trusts or farmland investing. You may be taking on exposure to all of these alternative asset classes. You may be having some cryptocurrency allocation in there. You might also be taking on individual stock picking instead of just being in index funds or index mutual funds. So those are the two kind of ends of the extreme, and then, of course, there’s a moderate risk profile in the middle, and I don’t just mean that there are only three buckets. This is a spectrum, right, and a person lives anywhere along that spectrum.

Determining Your Risk Appetite

When you decide where you are within that spectrum, your decision as to where you ought to be is going to depend on risk capacity, which is your logistical ability to survive some shock to your portfolio, and risk tolerance, which is your psychological desire to take on that risk. And so we wanna make a distinction between risk capacity, which is logistical, and risk tolerance, which is psychological. Both of those need to be accounted for as you’re making decisions about the level of risk that you want to take on in your investments in your portfolio.

Now, your capacity is going to be determined by a few factors. First, your timeline. If you are 25 but you very, very strongly want to retire at the age of 35 or 40, your time span is going to be different than that of a 25-year-old who has a goal of working until they’re 65. How long do you have until you want to start drawing down from these investments? Second, what are your goals? When I say goals, I mean personal goals like family, housing, lifestyle, as well as career goals. Do you want to make a midlife career change or not? Do you one day want to start your own business, or do you want to stay in the job that you have forever if possible?

In addition to that, income security has a lot of influence on your risk capacity. If you are a tenured professor, you have a lot of job security. You know that, barring some real catastrophe, you are going to be in a job with a predictable income stream probably for the rest of your life. That’s very different than being a freelance artist or a freelance musician. Also, if you’re relying only on one stream of income from one employer, you have diminished risk capacity, but if you have multiple streams of income — either from your main career plus a side hustle or maybe some rental properties that you own or royalties from a piece of software that you’ve developed or royalties from a book that you’ve written — then that gives you a buffer that helps increase your capacity to take on risk. So, the type of career that you’re in, the type of industry that you’re in, the security of that industry itself (Is it a growing industry? Is it a shrinking industry? Are you in print newspapers or are you in biotechnology?), and then how many streams of income you have.