This is not an article about risk tolerance, or how comfortable you are with market volatility.
That concept is very important, because many financial decisions involve uncertainty or risk of loss. All investors should be familiar with the idea that the volatility of your portfolio shouldn’t exceed your risk tolerance. Your money shouldn’t make you uncomfortable. What I’d actually like to explore is another reason why managing volatility is valuable:
Volatility takes away freedom.
To understand what I mean by that, let’s start with a different concept: liquidity. If you want to buy something that costs $100, you generally need cash, or something that can stand in for cash. Assets in a bank account are pretty close; most sellers nowadays are willing to accept checks or debit cards at the same price as cash. They may even prefer it! But even if they insist on cash, withdrawing cash at a bank branch or ATM is usually easy and either free or inexpensive. We say all of these assets are liquid.
On the other hand, some assets (like collectibles or real estate) are described as illiquid. Not only is it usually impossible to use them to pay for things directly, selling them typically takes a lot of time. If you have a piece of art worth $10,000, it’s usually not as simple as walking up to some corner exchange or cash machine to get that $10,000 to spend. You need to find a buyer and, ideally, go through some due diligence to make sure that the transaction occurs in good order.
But what if you need that money in a hurry?
You can probably make a legal transaction happen pretty quickly if you’re willing to accept much less than $10,000 and possibly pay some expedited fees. Therefore, while there may be some hard limits on cost and time, illiquidity is mostly an approximation of how much it costs, in either money or time, to get access to the value of an asset. This leaves you with a choice: do you want to give up some of the value of your asset, or do you want to delay being able to make use of that value?
In this sense, a diversified investment portfolio is very liquid. Usually, the vast majority (if not all) of the assets in a diversified portfolio can be converted into cash within a few days, and the transaction costs are quite small for most securities held at well-known brokerages. (Don’t forget about taxes, but that’s a topic for another time!)