If you're like many investors, your appetite for risk changes with the market's ups and downs. Unfortunately, this tendency can be counterproductive, leading you to buy during market highs and sell during market lows.
If you're wondering about your tolerance for investment risk right now, consider the following example question from a risk-assessment questionnaire:
When you think of the word "risk," which of the following words comes to mind ﬁrst?
Your answer to the question above is an indication of how you feel about investing. If your answer is "a" or "b," you may be less confident. If, on the other hand, your answer is "c" or "d," you may have a greater appetite for risk.
Now, consider this same question under different market conditions. Instead of the current bull market and the S&P 500 Index reaching record highs, imagine that it's January 2009, and the S&P 500 just dropped 37% during the previous calendar year. Would you select the same answer to the question above? Perhaps not-and you wouldn't be alone.
A recent study points out that investor risk tolerance can vary with market conditions. Between January 2007 and May 2012, a strong correlation of 0.70-a perfect correlation would be 1.0-was found between the S&P 500 Index and the monthly responses that a large group of investors gave to a number of risk-tolerance questions.
The study found that risk tolerance correlated well with the recent bear market, but not with the bull market that followed. During the market decline of January 2007 - March 2009, the correlation between risk tolerance and stock-market performance was very strong (0.90). However, during the recovery period of April 2009 - May 2014, the correlation was only 0.01. In other words, risk tolerance decreased as the market declined, but did not rise when the market recovered. This suggests that many investors fled stocks when the market declined and stayed out of the market, missing out on the rally.
A second part of this same study showed that investors' risk tolerance was higher after P/E ratios rose, and lower after P/E ratios fell. Based on this, the study concluded that investors may be more willing to increase their allocations to equities after prices have gone up and resist rebalancing into equities during market downturns, when valuations are most attractive.
Investors' tendency to move in and out of the market at the wrong time comes at a substantial cost. A study appearing in The Journal of Corporate Finance found that between 1991 and 2004, investors lost an average of 1.56% annually because they pulled money out of equity funds following a market decline and returned to equity funds after equity prices rose.
Because risk tolerance can change over time, it needs to be reassessed periodically, particularly after dramatic market moves. It's important that you think carefully about what risk means to you, and talk with your financial advisor to ensure you're taking the appropriate amount of risk to achieve your financial goals.
All investments are subject to risks, including possible loss of principal.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The article has been written by Hartford Funds' Investment Team. Hartford Funds is not receiving compensation for it. Hartford Funds has no business relationship with any company whose stock is mentioned in this article.