This past year taught us important lessons on risk tolerance

This past year taught us important lessons on risk tolerance

Disasters reveal risk tolerances. The COVID-19 pandemic highlights the cautious nature of most Canadians as we try to stay at home as 2020 comes to a close.

But some people are wired differently. They’re more tolerant of the risk of infection. They’re leaving the shelter of their homes and jumping on airplanes to enjoy southern climes this winter despite the urging of public heath officials to the contrary.

I know three carefree couples who are headed off to different destinations in the United States and Central America. I categorize one couple as young and at relatively low personal risk should the virus strike. The odds are worse for the others due to their advanced ages and comorbidities.

I hope they reconsider their plans, because the idea of travelling for pleasure at this time seems to me to be both unwise and not public-spirited. But they figure the trips are worth the risk and expect to be rewarded with a nice holiday. They might also get the opportunity to be vaccinated before other Canadians.

We’re faced with similar – albeit usually less deadly – risk calculations in everyday life. Sometimes the upside seems to be minimal and the downside substantial, as in the case of this winter’s holiday travellers.

On the other hand, we’ve all been enriched by risk takers who bet big on unlikely outcomes in fields such as business, science and the arts. Failures abound, but the winners helped lift humanity from the miseries of ages past. After all, without them the development of today’s vaccines wouldn’t be possible.

It’s also difficult to properly calibrate risks when it comes to investing.

The problem is, it’s easy for investors to overestimate their tolerance for risk in good times, only to wish they’d been more conservative when losses loom large during a market crash. Similarly, after the markets rebound, they might wish they had been more aggressive in bad times.

2020 provided a useful lesson. Much like the pandemic, the market crash wasn’t as bad as it could have been. Some past pandemics wiped out large fractions of the world’s population, and past crashes toppled fortunes, with market losses in excess of 50 per cent.

This time around the S&P/TSX Composite fell 38 per cent from its 52-week high on Feb. 20 to its 52-week low on March 23. Canadian bonds weren’t immune from the downturn, with the price of the iShares Core Canadian Universe Bond ETF (XBB-T) slipping 17 per cent from its high to low in March, which likely surprised many bond investors. While it was hard to hide from losses in March, both the stock index and the ETF rebounded and sported positive returns for the year by Christmas.

Reflect on the period and what it says about your tolerance for – and ability to deal with – market fluctuations. Think of it as training for the next downturn.

If you were overly nervous about your investments in March, it might be best to tilt your portfolio toward more stable assets for the longer term. If you panicked and dumped your stocks near the bottom, you probably shouldn’t be loading up on them today.

On the other hand, more risk-tolerant investors might have jumped on the opportunity and loaded up on stocks in March. After all, those who buy in bear markets tend to be rewarded, as I indicated in an article that happened to appear the day after the market bottomed.

Alas, the outlook for the stock market in 2021 is less than certain – as it often is. I fear we may be headed into a period – much like that after the turn of the century – of mediocre long-term returns. Stocks look poised to generate low single-digit annual returns – with a good deal of volatility – over the next decade or so. The outlook for bonds is particularly poor due to the unusually low yields on offer these days.

The high price of both stocks and bonds makes them riskier than they once were, in my view. It puts savers in a difficult spot because the bill for the pandemic will likely come due in the form of higher taxes, slower growth, inflation and the like.

My inclination on the eve of 2021 is to hunker down and save more than I originally planned, while keeping an eye on what can go wrong as much as on what can go right. But, like my friends flying south, the risk takers might win in the shorter run – at least until the market catches another cold.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.

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Published at Tue, 29 Dec 2020 23:00:51 +0000