Every time I work with a client, I make a bald statement of fact:
If you invest in growth-oriented investments, there WILL be times when the value of those investments will drop. Sometimes these drops will be significant.
If you can’t accept this, then you shouldn’t invest in growth-oriented investments such as shares.
The problem, however, is that by investing too conservatively, you are likely to end up in a worse position over the long run. Over the course of decades, inflation will eat away at the returns (if not the capital) of your investments, whereas over this timeframe, growth-oriented investments are likely to grow in value, despite the periodic ups and downs.
Another thing that I stress to clients:
A downturn isn’t a possibility. Over a long enough time frame, it is probable. In fact, it’s basically inevitable.
I don’t know the timing of downturns, how low they’ll go, and how long they’ll last. But I can tell you with certainty that they’ll happen.
This is a reality we need to come to peace with. On average, markets will fall:
- by 10% or more every 11 months;
- by 20% every three years; and
- by 30% every decade.
Markets will drop by 50% or more at least once during most people’s lifetimes.
(I credit these figures to Morgan Housel, author of The Psychology of Money.)
Balancing two different types of risk
There’s no such thing as an investment that’s free of risk. All we can do is weigh risks against each other.
One of the central tensions with investing in financial assets is balancing the following two risks:
- The risk of short-term volatility
- The risk of ending up in a worse position over the long run.
This is where having a good understanding of your cash flow needs and investing time horizon is so important.
If you need money for the short- to medium-term future – for a house deposit, for instance – you probably need to weigh the risk of short-term volatility more heavily.
If you are earmarking funds for the long-term future – for the twilight years of retirement, many decades into the future – then the risk of short-term volatility should be weighed less heavily than the very real risk of ending up in a worse position over the long run.
Of course, your personal tolerance for risk needs to come into the equation. But your tolerance for risk needs to informed by the realities of the risks that you’re facing.
If you know that you’re investing for the long run, and you’re investing in growth-oriented assets to build your wealth, then downturns will occur. Fortunately, you’ll have plenty of time for your investments to come back to where they were before you need them.