Do you really know your risk tolerance?

Almost 75 years after it was written, Fred Schwed’s Where are the Customers’ Yachts? remains one of the most entertaining books ever written about the investment industry. Here’s one of its best remembered lines: “There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”

As Schwed recognized all those years ago, no one can really gauge their risk tolerance by filling out a questionnaire, or by pondering standard deviations. It’s easy to say that you have a long time horizon and you won’t panic in a downturn. But the fact is, no one really knows how they will react until they have actually lived through a devastating bear market.

And if you only started investing in the last few years, you haven’t been tested yet.

According to a Bloomberg article published earlier this month, the S&P 500 has now gone more than 1,000 days without a correction of 10%. The last time investors enjoyed a run like this was a 1,127-day period that ran from July 1984 to August 1987, the article reports. If you’re under 40 years old, it’s fair to say you don’t remember that one.

The situation is similar in Canada: the last time there was a 10% correction was mid-2011. The Horizons S&P/TSX 60 ETF (HXT), a proxy for the total return of Canadian large cap stocks, has not seen a 10% decline since August of that year—almost 1,100 days ago.

It don’t mean a thing if you ain’t seen those swings

Not only have we managed to avoid a significant drawdown for close to three years, the volatility of the markets has also been well below average. Have a look at the standard deviation of Canadian, US and international stocks in recent years:

As you can see, the volatility of returns in Canada and the US has been about 50% lower in the last three and five years than it was during the past two decades. For even more perspective, the Credit Suisse Global Investment Returns Yearbook 2014 reports that the return of US stocks had an annualized standard deviation of about 20% from 1928 through 2013. Since mid-2009, it has been less than 9% (when measured in Canadian dollars). That’s a leisurely float down a river without many rapids and not a single waterfall.

A time for calm reflection

So what is the lesson for investors? I think there are a couple. First, if you’re young and just getting started, don’t make the mistake of thinking your long-term journey will always look like the last five years. These days I hear from a lot of new investors who say they’re comfortable with volatility, and they’re confident they can handle a 100% equity portfolio. But they haven’t really experienced volatility, and except for a short-lived downturn in 2011, they haven’t suffered a significant loss. A word of advice: your risk tolerance probably isn’t as high as you think.

Second, periods of low volatility provide a good opportunity to firm up your long-term investment strategy. The best time to make changes to your portfolio is when you’re feeling calm and rational. So if you’ve been procrastinating about dumping your high-cost active funds, investing that idle cash, or adjusting your asset allocation to keep it in line with your goals, then now might be a good time to do that. Because when this winning streak finally ends—and it will, though no one knows when—any changes you make are likely to be based on fear and emotion. And we all know how that works out, don’t we?

Dan Bortolotti is the consulting editor of MoneySense. He blogs here and at canadiancouchpotato.com. Find him on Twitter @CdnCouchPotato.