Most people poorly understand tolerance for investment risk. They also have a flawed – or even absent – understanding of the risk in their current investments.
Understanding risk tolerance and how it aligns with actual investment risk is crucial to your own investing. For instance, how do you respond not only to the downward jolts but also to euphoric market times? How does the current mood of the market affect your buying and selling decisions?
You can measure risk tolerance several ways, none ideal on its own. Most overly emphasize your age as the key factor, for instance.
You can take surveys to determine how you respond to certain circumstances; complete questionnaires that evaluate your preferences for growth versus protection; take personality tests relevant to investing. A combination, along with understanding your past investing behavior, works best.
You need a strong sense of your tolerance for fluctuations in markets because the best investment strategy for you – regardless of whether you’re conservative or aggressive with your portfolio – is the strategy you can stick with.
How much risk? Before labeling your investments as too risky, understand how risk relates to your financial goals.
A comprehensive financial plan that identifies whether your financial future is on track or at risk also helps you decide how much growth-seeking risk to take. Your plan can also identify the magnitude of risk in your financial life. Falling a few dollars short of your low-priority goals, for example, differs a lot from falling a few dollars short of your essential goals.
A plan aligning your goals with your financial resources can identify that tipping point at which a decline in your account’s value becomes devastating or at what point you can ease saving and spend more. The plan also helps reconcile how you and your spouse – who may have very different risk tolerance – can manage money decisions jointly.
Though you have little control over the short-term direction of investment markets, you do control how you balance risk versus reward in your long-term investment strategy. As Peter Bernstein wrote in Against the Gods: The Remarkable Story of Risk:
“The word ‘risk’ derives from the early Italian risicare, which means ‘to dare’ … The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about. And that story helps define what it means to be a human being.” And a successful investor.
Manage risks you can’t control. Making decisions from the framework of a financial plan allows you to assess your risks and what they mean to you. For some, risk is running out of money before they run out of time and die. For others, risk means being unable to live the lifestyle they want or support the people or organizations they care about.
Measuring both personal risk tolerance and the level of risk in your investments facilitates use of scientific method in investing and financial planning.
Among the simplest questions in a formula: How’s the market performed overall in the past 20 years? How are your assets diversified between stocks and bonds? How do you feel if faced with losing half the value of one of your assets?
Record your observations and test ideas as your life, goals and investment opportunities change.
A quantifiable assessment of your risk profile won’t assure you consistent short-term investment victories; luck is always involved. But a good process that mixes science and art when managing investment risk – and your response to that risk – can beat luck over the long-term.
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Written by Gary Brooks, a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Tacoma, Wash. Find risk tolerance resources at his blog The Money Architects.
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