On why investors need to understand their investment risk tolerance and align expectations before starting to invest.
The Growing Trend of Misunderstanding Investment Risk Tolerance
As I scroll through the comments feed on the Almost Daily Dividends Pie over on Trading 212, there’s a growing trend of people getting into something they seem not to fully understand.
Firstly, it’s the never-ending war against people asking:
- “What’s the yield?”
- “Why haven’t my dividends come in yet?”
This is despite the fact that these questions are clearly answered in the Ultimate Guide to the (Almost) Daily Dividends Pie. This guide, by the way, is heavily advised to have been read before investing.
But more recently, there’s a new problem: people investing in equities or the stock market who don’t really understand how investing works in the first place.
Let’s take a look at a recent post so you can see what I mean.
“What’s the point in investing in this risky pie for only a 3.2% return—if the stocks don’t tank (which they currently have) when you can keep the money in a savings ISA and get a 3% return with zero risk?”
Now, there are fundamental problems with this comment in almost every part of the sentence.
Breaking Down the Misconceptions of Risk Tolerance
Risk Is Not Binary
The concept of “risk” is not binary. It’s not the case that some things are “risky” and others are “safe.”
Calling it a “risky pie” is, in a sense, nonsensical, because there’s a spectrum of risk in anything you invest in.
It really depends on what you’re comparing it to to call it “risky.”
How far along that spectrum of risk anything is in comparison to alternatives.
It’s Not a Guaranteed Return
That 3.2% figure was only the previous dividend yield calculation, and you can see the AAR (Annual Average Return) in the description of the pie on Trading 212.
Total return is a combination of dividend yield and how much the stock has gone up or down over a period of time.
Comparing dividend yield to the return from a cash ISA is a closer comparison, but it misses a bigger piece of the puzzle of total return from your investment.
Anyway, there is no set level of return you’re guaranteed each year.
Investing in stocks never works like that.
There is No “Zero Risk” in a Savings ISA
This might be surprising for some people to hear, but there’s also risk involved in a cash or savings ISA.
For example, you’re highly exposed to inflationary risk.
If you’re keeping money in a cash ISA for the long term, your money will underperform inflation, and the real value of your money will actually decrease over time.
The Real Issue: Short-Term Thinking in a Long-Term Game
But the main point I want to address in this video and post is the implication that, because stocks have recently, in the poster’s words, “tanked,” it means this is a general trend.
Here are a few comments I found from a quick look:
- “I’m still in the red on this pie—the value is getting hammered lately.”
- “I’ve recently invested, and I’m currently down 5%. Is this something to be concerned about?”
- “Here’s to another bad day.”
As a new investor without background knowledge, seeing red in your portfolio can be unnerving.
Your money seems like it’s gone, perhaps even disappeared forever.
It’s scary.
I get that.
No one actively wants to lose money, especially nowadays, when every pound doesn’t go as far due to the cost-of-living crisis.
But here’s the amusing thing:
If you scroll just a little further into the pie’s history, you’ll see a completely different picture.
The pie was one of the few things that did decently well in 2022 and kept many people’s total portfolios afloat.
It’s also what led to its massive growth in popularity in 2022.
As I make this video, there are approximately 185,000 active copies in the Pie.
And here’s what the majority of comments looked like just a few months ago:
- “That was a nice jump the pie did today, things are looking good!”
- “I just want to say a massive thank you to the owner of this pie. I’m currently up 8%, and I couldn’t be happier. Thank you so much for creating this pie!”
- “I follow you on YouTube as well, and I always look forward to the updates. Thank you!”
And then, very recently, after all the negative and panic comments of the last couple of months:
“Doing well this week, eh?”
Panic about stock volatility is common
This is a tale as old as time:
- When stocks go up, people get euphoric –“Nothing can stop me! I’m king of the world!”
- When stocks go down, the pitchforks come out, accusations fly, and portfolios are sold at a loss out of fear.
Serious investors don’t do this.
What they know is that historical data consistently demonstrates that, over the long term, stock markets tend to generate positive returns despite short-term market fluctuations.
The overall trend of the stock market has been upward.
Long-term investors who stay invested have the potential to capture these long-term gains.
Does This Guarantee Gains?
No. I can’t guarantee that you’ll make gains investing in the Almost Daily Dividends Pie or any kind of investment, realistically.
That’s the catch with investing in equities.
While most of the time you’ll probably be a winner, stocks do go down.
If you’re picking individual stocks, there is a risk that your investment could go to zero – or never reach a higher price than what you paid.
How Do Long-Term Investors Stay Calm?
Volatility Is the Cost of Entry
The first thing you need to be aware of is that volatility and market cycles are essentially paying the cost of making money in the stock market.
Financial markets naturally have ups and downs. Prices change due to various factors like the economy and investor sentiment.
Long-term investors know that short-term drops are a normal part of market cycles.
They understand that markets tend to balance out over time and investments can recover and grow.
Your Mindset Matters
You need to have the mindset of a long-term investor.
Long-term investors think very differently from short-term speculators.
They focus on the long run, understanding that investment success is not defined by daily fluctuations.
Instead, they look at the overall growth trajectory over time. This patient and disciplined approach helps them avoid being influenced by short-term market noise.
Clear Goals and a Plan
Long-term investors also have clear financial goals and an investment plan aligned with those goals.
In essence, before you invest, you really should know why you’re investing as well as making sure that the plan aligns with your investment risk tolerance.
If you don’t have a target or a goal, it’ll be much easier to convince yourself that you need to sell in a panic because you’re not working toward anything specific.
Long-term investors know that short, small price drops don’t fundamentally change their long-term prospects. Therefore, the ultimate strategy has not changed, despite a bit of a scary period where you are in the red.
Instead of worrying about short-term falls, they stay focused on the bigger picture, knowing their investment can provide significant returns over extended periods.
Benefits of Staying Calm
While short-term fools may worry, long-term investors stay calm and composed.
They understand that reacting emotionally to market movements can lead to irrational decisions that harm their wealth.
By staying composed during downturns, they:
- Avoid selling in a panic
- Protect their investment capital
- And see falling prices as a potential opportunity to buy more shares at lower prices
This strategy, known as dollar-cost averaging, lets investors lower the average cost per share in the long run.
This can potentially increase overall returns when the market eventually recovers.
What If You’re Still Worried about a Downturn in Share Prices?
Here’s another point I want to make:
It might just be the case that investing in stocks isn’t for you… right now.
This is not meant to sound harsh or mean or me being a gatekeeper on investing or something – it’s genuinely a serious consideration.
Moving from the relatively safe world of savings to the relatively riskier world of investing may not be right for you at this particular time.
Here are some things you should really consider and questions you should ask yourself:
Setting Clear Investment Goals
- What are your financial objectives?
- What’s the purpose of your investments?
- Are you saving for retirement, a down payment on a house, or another specific goal?
Having a clear goal helps guide your decisions and creates a framework for your strategy.
It also prevents you from selling at the wrong time when you’re scared, because you’ll know deep down that you’re undoing your progress.
Understanding Your Investment Risk Tolerance
- Have you assessed your investment risk tolerance?
- How comfortable are you with fluctuations in your portfolio value?
- Are you aware of the inherent risks in stock market investing—including the potential for losses?
- Have you considered your financial situation, investment horizon, and emotional capacity to handle market volatility?
A lot of the comments I’ve seen are from people who are clearly not comfortable with the level of risk they’re taking.
Personally, I wouldn’t be remotely concerned until we see drawdowns of around 15% for The (Almost) Daily Dividends pie.
Since I created it over 5 years ago, we’ve not gotten to that level, so I’m currently not concerned and haven’t been (yet).
Your situation may be very different. You may even be willing to take more risks.
Educating Yourself About Investing
- Have you taken time to learn the basics of investing in the stock market?
- Are you familiar with concepts like diversification, asset allocation, and risk management?
For those unsure where to begin, I have now created The Dividend Academy – a fully comprehensive course on investing that updates over time.
Starting with a Solid Financial Foundation
Before diving into the stock market, have you:
- Paid off high-interest debt?
- Built an emergency fund covering several months of living expenses?
- Set up a budget to manage your expenses?
There’s no good investing your last pound into the stock market if you know you’ll need it a week later.
Having money that you need or can’t afford to lose going up and down in the market is way more stressful than just investing the ‘extra money’.
Determining Your Investment Time Frame
The time frame is very important and will help determine what kind of things are more appropriate for you to invest in.
You can ask yourself:
- How long do you plan to stay invested?
- If you have a long-term horizon ( this means several years or more), how can you benefit from short-term fluctuations and compounding returns?
- If you have a shorter time frame, how might you need to adjust your approach to protect your capital?
Investing gurus and smart finance people say you should usually invest for at least five years. This is to give the good times in the stock market a chance to outweigh the bad times.
What Should You Do Next?
Did you answer yes to most of these questions? (Well, the ones that were yes-or-no questions, I mean.)
If you did, then ask yourself the final question:
“Why are you even looking at your returns every day?”
You’re investing for the long term, aren’t you?
Prices are simply going to change every day.
But what if you answered no?
Then it might mean you’re not ready to invest yet, or you need to reorganise your portfolio to build a lower-volatility portfolio that better fits your current investment risk tolerance.