In my experience, eight out of 10 people have a poor understanding of their tolerance for investment risk. Compounding this problem, many people have a flawed — or even absent — understanding of the actual level of risk inherent in their current investments.
A meaningful understanding of risk tolerance and how it aligns with actual investment risk is a common tenet of successful investors. How will you respond not only to downward jolts but also in more euphoric times? What effect does the current mood of the market have on your buy and sell decisions or whether to participate in an exercise of unknown short-term outcomes?
There are several ways to measure risk tolerance. None is ideal on its own. Most put too much emphasis on your age as the key factor. You can take surveys to determine how you might respond to certain circumstances. You can complete questionnaires that evaluate your preferences for growth vs. protection. You can take personality tests that are relevant to investing because money is a personal, emotional activity influenced by how you perceive yourself, the future and the world you live in.
A combination of these measures, along with an understanding of your past buy/sell/save/spend behavior is important. It is critical that you have a strong sense of your tolerance for fluctuations in markets because the best investment strategy for you — regardless of whether you are naturally conservative or aggressive — is the one you can stick with.
Investors who shift their preference based on current market conditions (exhibiting recency bias by projecting current events, both good and bad, too far into the future) often suffer underperformance, which creates a different risk — not reaching your goals.
HOW MUCH RISK TO TAKE
Before determining if your investment holdings are too risky, it’s a wise exercise to understand how risk relates to your financial goals. A comprehensive financial plan that identifies whether your financial future is on track or at risk can be informative in deciding how much growth-seeking risk to take with your money. The plan also can identify magnitude of risk in your financial life. If you fall short of your low-priority goals by a few dollars, it’s much different than falling short of your essential needs goals by many dollars. Each may signal a failure point in a plan but represent different risks. A plan that aligns your goals with your financial resources can identify the tipping point at which a decline in account value becomes devastating or at what point you can ease saving and spend more with confidence.
The people who make the best personal finance decisions have a plan that identifies their margin of safety for accepting risk and what their signals are for smart course corrections along the way. The plan also helps reconcile how spouses with different risk tolerance can manage money decisions jointly.
Remember that while you have little control over the short-term direction of investment markets, you do have control over how you balance risk vs. reward in your long-term investment strategy. As Peter Bernstein wrote in his book, “Against the Gods: The Remarkable Story of Risk,” “the word ‘risk’ derives from the early Italian risicare, which means ‘to dare’. In this sense, risk is a choice rather than a fate. 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 what your risks actually are and what they mean to you. For some people, risk is running out of money before they run out of time. For others, it is not being able to live the lifestyle they want or support people or organizations they care about. In another sense, risk is exposing your family to harmful financial events without insurance coverage.
Measuring both personal risk tolerance and the level of risk exhibited in your investments allows for the use of some scientific method in investing and financial planning. We can record observations, measure, formulate and test ideas and modify our hypothesis as lives, goals and investment opportunities change.
Having a quantifiable assessment of your risk vs. return profile won’t assure consistent short-term investment victories, because there is some luck involved. But a good process — taking into consideration the mix of science and art when managing investment risk and the response to it — should outweigh luck over the long-term.Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Old Town Tacoma. Find risk tolerance resources at his blog themoneyarchitects.com.