English Guide

How to define your investment risk

You cannot know the evolution of market prices. Nevertheless, you can decide in which types of assets, with different risks, you want to invest.

No one knows the evolution of market prices. Nevertheless, you can decide in which assets, with different risks, you want to invest. Jonathan Clements puts it this way in “You’ve Lost it. Now What?”: “Costs and risks can be controlled. Performance is in the hands of the gods.”

There are different individual attitudes to risk: Gamestop buyers in February 2021 or those trying to play the market, see the stock market more as a short-term speculative game. At the other end of the spectrum, you’ll find people who still regret not having invested, who find the level of the stock market too high and are sitting on untapped savings forever. The fear of taking any risk and seeing their savings change in value paralyze them. I understand the playfulness and need for thrills, as well as the fear of investing for some, but you will find a more solid and serious long-term approach here.

To build a diversified portfolio across different asset types, you must first understand your capacity and risk tolerance. Your capacity defines the level of risky assets you can hold (between having no savings and to holding large reserves) and your tolerance depends on your ability to accept losses (if your stock portfolio fell by 20%, would you be calm, find yourself in some state of agitation or lose sleep?). In your lifetime, it is possible that such a crash will cut your portfolio in half. This can be very stressful and you should not panic if it happens. If this thought scares you, your loss tolerance may be low and you should only enter the market gradually and with small amounts.

In pre-2008 market environments, the key portfolio decision was to determine the percentage of stocks and bonds that fit your risk profile and stage of life. John Bogle suggested investing roughly your age in bonds; for example, if you are 65 years old, you could have invested 65% (or between 50% and 80%) of your wealth in a diversified bond portfolio.

In today’s ultra-low interest rate environment, a new investor should avoid bonds for the time being, until rates rise again. Most importantly, you need to define your risk capacity and tolerance for stocks. So far, with a few exceptions, the global economy and equity markets have always performed well over the long term. In the short term, due to liquidity squeezes, conflicts or other crises, stocks can lose a lot of their value. So with good returns on average comes significant risk, especially for individual companies. Diversification helps mitigate this risk without reducing potential returns, but very sharp corrections and long-term declining markets are possible. Because of the efficiency of the markets (i.e., prices incorporate publicly available information) and the difficulty of beating the market, a diversified passive portfolio is best suited for most investors.

In practice: To offset potential losses in stocks and avoid bonds, it is best to consider a mix of volatile investments such as stocks and stable assets. If you have a company or government pension, you can add it to your stable assets. If your risk capacity allows and you are looking for more excitement with speculative bets or crypto-currencies, I suggest you consider them as a casino account and keep them at a reasonable level (no more than 10% of your total wealth and considered over your entire life) as you may well lose it all!