There is nothing like a sudden drop in the sharemarket to send investors into a panic. It is easy at the time of investing to be full of confidence and to see yourself as someone willing to take risk in exchange for the potential of a higher return. But when volatility strikes confidence can quickly be eroded.
Volatility quickly sorts out those investors who truly understand their tolerance and capacity for risk and those who don't. The principal risk-management tool for sharemarket investors is diversification. For small investors, that can be achieved through investing in a fund.
Investors who ignore the principle of diversification are in effect speculators rather than investors, believing they can pick winners and taking on higher risks for the chance of higher returns.
A diversified portfolio of shares will mimic the behaviour of the market as a whole, reaching neither infinity nor zero in value, but remaining close to the market trend line. The key risk for diversified investors becomes one of how long funds need to remain invested for the market to return to trend. A loss will only be crystallised if investments are sold before this happens.
This is where the concept of risk capacity is important, that is, the ability to absorb loss without significant impact on your overall financial situation. Investors with a short timeframe or a low level of wealth or income are more likely to have a low capacity for risk.
