Risk Tolerance and Volatility

With continued volatility in the markets, we thought it would be a good time to remember why we think about risk tolerance first and then build our asset allocation based on our unique risk tolerance.

The chart below shows the performance of three different Vanguard index funds (admiral share class) over the past month and since January 1, 2020.  The funds are the Vanguard Total Stock Market Index (US Stock Market), Vanguard Short-Term Government Bond Index and Vanguard Intermediate-Term Government Bond Index.

We believe that the most important takeaway from this chart is that while the stock market is dropping and getting all the headlines, government bonds have been performing very well.  This is because when investors panic, they sell risky assets (e.g., stocks) and buy safe assets (e.g., government bonds).  

The reason this is important for us to remember is that we want to build your portfolio with a mix of risky and safe assets that aligns with your ability and willingness to take risk, otherwise known as your risk tolerance.  If you have a higher risk tolerance then you will have a higher allocation to stocks and experience larger changes in the value of your portfolio.  Conversely, if you have a lower risk tolerance, you will have a higher allocation to high-quality bonds and experience smaller changes in the value of your portfolio.  The right mix depends on the emotions and net worth of the individual investor.  

As another volatile week ends, remember that not all assets perform poorly at the same time, even though you would never know it from reading the newspaper.  Further, if your portfolio was constructed using your unique risk tolerance, you are well positioned to ride out short-term volatility in the pursuit of long-term wealth creation.