Does a 10-20% downturn make you sick? How would you feel if you missed out on a 20% gain? These are two very different questions, but both are equally important when deciding how to invest your money.
Although "risk tolerance questionnaires" aren't the be-all-end-all when determining how to invest, they at least make the investor think about their emotions. But how do you know if you're taking on too much volatility in your portfolio? How do you know if you're not taking on enough?
When new prospects ask me, "what's your clients' average return?" it's literally impossible to answer. I generally follow it up by saying something like, "I'm not sure, what type of portfolio do they own? 100% stocks? 50/50? 100% bonds?" Every client is truly different. I have a retired client that has a written goal to earn 10% per year on average - is that possible? We can't predict returns, nor do we try. However, to even come close to 10% annually, the portfolio is very volatile. That investor is okay with that. They could be up or down 5-7% in any given DAY. It's probably safe to say that most clients cannot handle that type of volatility. Therefore, they simply cannot own extremely volatile portfolios. You can't have it both ways - there is simply no investment in the marketplace that has high returns and zero risk or volatility.
Sometimes investors have to ask themselves a question about investing when deciding on what portfolio is right for them.
What would make you feel worse:
Moving to cash (or something very low risk) and missing out on a 20% gain?
Staying invested and experiencing a temporary 20% decline?
Example: If someone wanted to buy a home in the next 6 months, would they feel worse if they lost 20% of their money for a downpayment in the stock market (just by sake of timing) OR would they feel worse if they stayed in cash (for the downpayment) and missed out on 20% gain. At that point, the client is managing risk. The goal is to make sure each dollar has a job and that you're never in the position where you *have* to take money out when the market is down.
When picking the correct portfolio or allocation, you have to have something you can live with. If you can't ride out a stock market decline of close to 15% every year (from peak to trough), and a decline averaging twice that, about one year in five, you simply cannot be a stock investor.