Imagine this: Your best friend calls and says it would be fun to do a tour of California later this month. She says, if we get there by noon next Friday, we could make it to a popular music festival where our favorite bands will be playing. You say “YES” emphatically, pack up your stuff (including your guitar) and head out on the open road. You’re feeling great, filling the car with laugher and song.
But, then you get to Atlanta, you hit a massive traffic jam and start panicking. You haven’t moved an inch in 2 hours. You think you’ll never make it at the rate you’re going. You start overestimating how long it’s going to take based on this current setback. You’re ready to reverse course, since missing out on the music fest would make the whole experience a waste of time.
That early traffic jam is like volatility in the markets. It’s easy to focus on what’s fresh in your mind, but if your focus solely remains there, it can paralyze your thinking and hinder your ability to achieve your goals. If you focus instead on when you need to get there (timeline) and how fast you can reasonably drive (long-term returns), you can navigate the journey with better confidence and a better chance for achieving your goal.
This goes to the heart of what is real risk. So let’s dive into it further….
Risk and return typically go hand-in-hand. The more return you wish to earn, the more risk you must be willing to assume. That makes sense. But you may be wondering, how do I measure the risk I have to assume?
Some investors may evaluate risk based on how much the price of their investment bounces around, i.e. volatility. The greater the fluctuations, the greater the risk. Others may define risk more in terms of their goals. What are the chances I won’t have enough money to fund one of my financial priorities, i.e. the down payment on a new home in two years. My child’s college education in six. My retirement in ten.
Both measurements are helpful, but we believe it’s better to view risk through the lens of your goals. Why? Well, in the short-term, price movements can seem random, based on a million different factors that constantly change. They could include perceptions about a company’s prospects, that of its industry or where it’s located. Each investment is then compared against other investments.
But, unlike natural sciences like weather forecasting, investing is a social science. The same exact conditions can yield completely different results. It all depends on the mood of the millions of other investors. So, if the weather was like investing, it might rain when it’s 20 degrees and snow when it’s 50. The only way to know would be to get inside each and every investor’s head…and stay there. Good luck with that. Even if you could, you’d probably need to take up permanent residency inside a shrink’s office!
Investing legend Warren Buffett once said, the stock market in the short-term more closely resembles a voting machine where each purchase or sale is a vote on the prospects of an investment. But, over time, it becomes a weighing machine that gives more weight to companies that earn more.
That’s why it can be misleading to measure an investment’s risk based purely on how much its price bounces around. It may not accurately account for how well a company is growing its earnings, but more so, the current mood of the market. So, we believe investors would be better served focusing instead on the weightiness of an investment (earnings) and the timeline for their own, personal goals. These two factors will help better determine your asset mix: how much money you should put into stocks. How much should go into bonds. How much should remain in cash.
Want a clearer picture of your personal investment journey so you won’t consider reversing course before reaching that awesome music fest in Cali?
This material is provided as a courtesy and for educational purposes only. Investing involves risk, including the loss of principal. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.