How well can you handle market volatility?
Gearing up for the next turbulent market.
A holistic view of risk balances probability and consequence. I have an immense fear of sharks. I know the probability of being attacked by one is incredibly low, however the consequence of it actually happening is significant. For me, it’s high enough to avoid entering the ocean altogether.
On the other hand, I recently discovered that 7-eleven does $2 coffees – a break from my usual $6.50 indulgence. Maybe this is the secret pathway to homeownership. Anyway. When I buy a scratchie during my routine 7-eleven trip, I know the probability of losing is incredibly high, however the consequence is only a few dollars’ worth. Most would perceive this as a low risk investment in isolation.
Determining your risk profile is one of the foundationalaspects of portfolio strategy. However, sticking to that is easier said than done. Many investors overestimate their ability to handle market volatility until a substantial downturn arrives.
Risk tolerance and risk capacity
It’s important to note that there is a distinction between risk tolerance and risk capacity. Christine Benz wrote a great article on it here. The short version is our capacity is based on our circumstances such as age, financial situation, family dynamics and most importantly our goals. Our risk tolerance is a subjective measure of whether we can stomach potential loss and volatility in exchange for higher returns.
Christine makes the point that investors need to mend fences if there is a disconnect between their tolerance and capacity, otherwise it can be devastating to long term goals.
Psychological risk
The reality is that most people simply aren’t as risk tolerant as they’d like to think. It is an easy trap to fall into when you’re young, have a high growth portfolio and / or no need of immediately liquidity. The list goes on. We’ve all got self-professed diamond hands when the market is doing well.
Bull markets or shorter bear markets (such as the post covid drop many recall) can encourage this false sense of security. However, a study found that self-described aggressive investors are more likely to engage in panic selling during downturns, even when financial literacy is considered. The reality is your behavioural responses (rather than your asset allocation) will always reveal your true risk tolerance. So why does this happen?
Herd mentality and loss aversion
Younger investors have consistently surveyed as confident. In some cases, this confidence veers into ignorant overconfidence. And it’s hard to blame us. Admittedly, my only experience with a bear market was conveniently the shortest bear market in history – the covid fallout. But in my defence, it’s not just my generation.
A lot of us are emotional investors. After all, emotion and financial decisions go hand in hand. It is almost impossible to maintain a strict level of objectivity when managing our own funds, which can lead to unfavourable outcomes.
Loss aversion is the notion that losses hurt us far more than equivalent gains. Herd mentality refers to the tendency for human behaviour to mimic the actions of a larger group. These common behavioural biases often impact our risk tolerance in periods of volatility.
The tariff fiasco in April is prime example of these behavioural biases. Some investors were willing to liquidate at almost any price leading to one of the steepest and shortest selloffs in market history.
The following weeks saw the market rebound despite the doomsday predictions many were pedalling a few days prior. Now we could argue whether these were all speculators or genuine investors falling victim to psychological constrains– but the logic stands. These behavioural biases expose our true risk tolerance. Understanding these biases helps us manage emotions rather than react impulsively.
Source: Macrobond. Morningstar.
Determining your risk tolerance
Do risk tolerance profiles work?
Unfortunately, many of us learn about our risk tolerance the hard way – retrospectively. But is there a solution to this?
If you’ve ever engaged a financial adviser or perhaps a robo-advice product, you’ve likely come across a risk tolerance questionnaire. The purpose is to evaluate your answers across different scenarios to determine how much risk you could hypothetically stomach. Questions are typically in the tone of ‘If one of your holdings fell 10% in a month, would you buy, sell or hold?’, with your answer implying your willingness to pursue risky trade-offs.
I have a few issues with the utility of this.
Firstly, I’d argue it’s almost impossible to know your risk tolerance until you face a potential loss. Furthermore, such quizzes rarely consider what you’re trying to accomplish through investing. A retiree and a 25-year-old might answer the same question very differently, but not because they have different risk tolerances, but because they have different goals. Therefore, it’s hard to argue that these answers in isolation indicate anything behaviourally conclusive.
Such questionnaires also create a chicken and egg dilemma. What if someone told you that you’d never reach your goals unless you took more risk? Would that reframe your tolerance? Probably. This can spiral into a loop where investors chase a moving target, rather than anchoring their tolerance to meaningful goals.
Risk tolerance isn’t just about how we survey, it’s about how we react when a crash actually comes. This conclusion isn’t that attempting to assess your risk tolerance preemptively is a useless exercise. But personally, such things fall in my category of ‘nice to have’ but not essential. Ultimately, the real risk in investing isn’t losing some money (as terrible as it is), it is failing to achieve your investment goals.
How we measure investment risk
We can’t round off this conversation without talking about fundamental risk – something present in all investments. A goals-based investing approach means we must evaluate assets to determine whether their inherent risk suits our strategy.
Your risk tolerance provides a framework for quantitative investment risk that is within acceptable boundaries during the portfolio construction process.
Standard deviation
Standard deviation is often used as a proxy for investment risk. The calculates how widely a stock or portfolio return varied from the average over a historical period. Using the standard deviation of historical performance can help investors estimate the range of returns for a given investment. A high standard deviation implies that the predicted range of performance is wide and therefore the investment has greater volatility. Most people define risk tolerance as how much volatility they can stomach.
If returns follow a normal distribution, ~68% of the time they will fall within one standard deviation of the average investment return. ~95% of the time returns will fall between two standard deviations.
For example, a portfolio with an average return of 15% and a standard deviation of 10%, would result in an expected return between 5 and 25% roughly 68% of the time. And 95% of the time we can expect returns to be between -5% and 35%.
For long term investors, the role of volatility becomes less significant. The real risk is not earning high enough returns to meet your goals or suffering permanent capital loss.
Sharpe ratio
The Sharpe ratio is one of the most widely used measures of risk-adjusted relative performance. It subtracts the safe market return from the expected return of an investment and ultimately divides that by the standard deviation.
If you have two hypothetical investments that both return 10% p.a. over the long term, the investment with the higher Sharpe ratio provides better risk-adjusted returns on the basis of lower standard deviation. In basic terms, you get a smoother ride to the same destination (although this rarely occurs in practice).
Sharpe ratios are not without their limits. The core assumption is that returns are normally distributed which often isn’t the case in overly volatile investments. This may lead to an underestimation of risk in portfolios with fat-tailed distributions (where extreme gains and losses occur more frequently than predicted by a normal distribution).
You can read more about standard deviation and the Sharpe ratio here.
Beta
Beta is a relative risk measure that looks at the volatility of a single stock versus the overall volatility of the market it trades in. The market is ascribed a beta of 1 and stocks are ranked by how much they deviate from the market. For example, BHP Group has a 5-year beta of 0.68, meaning the price is generally less volatile than the market, and its movements are typically 68% of the market’s movements. If a stock has a negative beta, that means it generally moves in the opposite direction to the market. This is a key component of the Capital Asset Pricing Model, that estimates the expected rate of return for the given risk of an investment.
There are several other quantitative measures of investment risk, however these three are the most common.
How to prepare
So, what can we do about this to better prepare for volatility and improve risk tolerance?
Define your investment goals and strategy. A lot of investors partake in the market with one simple goal – to get rich. Whilst such proclamations make great movies, they also result in terrible investment decisions.
A strategy will ultimately provide structure around decision making e.g. asset allocation. This informs both the what and when of buying and selling assets. Reviewing both your thesis and strategy can be a good grounding mechanism during volatile periods.
In her article Christine discusses employing hybrid-type funds that are exposed primarily to stocks but also hold smaller positions in more-conservative securities that help tamp down volatility. Investors can also do this though tailoring their growth and defensive asset allocation, but employing a fund does simplify the process.
I realise suggesting portfolio diversification here may elicit some eye rolls however the sentiment can’t be understated. Mark proposes the below diversification checklist that is a useful starting point for investors.
- Start with the mix between growth and defensive assets.
- Determine your asset class, geographic and sector exposures.
- Diversify at the holdings level to remove security specific risk.
And finally, keep calm.
Sometimes I think a little perspective pays off. Investors have weathered a series of seemingly destabilising events to ultimately come out on top. The chart below from Owen Analytics visualises a series of market-moving global events and the nominal returns of Australian and US shares. It appears that despite a constant stream of crises, markets demonstrate an overall upwards trend. Patience and rationality tend to pay off.
Source: Owen Analytics. 2025.
