Things That Go Bump in the Night

Anxiety about investment performance could ruin a good night’s sleep

October 30, 2017 | Insight

Photo by Beth Teutschmann on Unsplash

With the Halloween season upon us, thoughts of ghosts, gremlins and things that go bump in the night can keep young revellers from sleeping. For some adults, it’s anxiety about their investments’ performance that could ruin a good night’s sleep.

If you worry about your portfolio experiencing a sharp decline in value, you’re not alone. The potential for sharp downturns and market crashes consistently rank among investors’ top concerns. We frequently see advice in the financial media urging investors to assess their personal risk tolerance in order to better mitigate their exposure to it. It’s good advice if “risk” is defined as the degree of volatility in investment returns that an investor is willing to tolerate, but is that what is most important?

We think that the important thing is that your portfolio produces a return sufficient to achieve your financial goals, both in the near term and long term. With a clear focus on your goals and the time available to accomplish them, it is much easier to manage the emotional reaction to temporary downturns, even the occasional severe one.

A portfolio should be designed to produce the cash you need when you need it. A strategy that addresses this involves dividing your portfolio into two key components: A) risk-free assets (e.g., cash and government treasury bills) and B) growth-oriented assets (e.g., stocks). Your risk-free assets should include enough cash and short-term interest-bearing securities to cover your needs over the next few years – living expenses say, or the cost of a new car or home renovations. Your growth-oriented investments may be volatile but should consist of successful and growing businesses acquired at a discount to their economic value. The growth-oriented assets will experience periods of strength and periods of weakness and it is during those strong periods that cash holdings can be replenished as needed.

Someone gainfully employed and building an asset base to finance retirement twenty years from now, needn’t worry about a dip in value of the portfolio, and even less about a price drop on a single stock in the portfolio, provided they can be confident that the drop is temporary.

If you can be confident that the drop is temporary, even a significant downturn becomes less daunting. It could even be viewed as an opportunity to buy. So how do you know whether the drop is temporary or permanent? That’s where it is beneficial to own a good quality business and have a good idea of its economic value as opposed to its quoted price. It is also helpful if the investment was originally acquired for less than its economic value. With both of these things on your side, it is much easier to weather the inevitable downturns.

So, we come to the essence of the matter. Managing risk has less to do with the emotional impact that a price drop may have on you, and more to do with the effect it may have on the likelihood of you accomplishing your financial goals. The question is not how much volatility you can tolerate, but whether your portfolio contains first, enough cash to meet near-term requirements to avoid selling shares at unattractive prices, and second, shares of successful, growing businesses that were acquired at a discount to their economic values with the view to be a long-time owner.

Structuring a portfolio like this should go a long way toward calming the emotional reaction to portfolio downturns. Unlike a stomach full of too much candy and chocolate, a sound investment strategy will assist in getting a good night’s sleep.