Over long haul, understanding risk is more important than finding investment ‘winners’

Abundant resources offer investment tips about what you should buy now to prosper in the coming year. The likelihood that these recommendations find your attention might be high, but the likelihood that the picks turn out to be market-beating wonders is low. For the sake of your long-term financial security, shift your focus to start 2022 by gaining an insight about yourself that can make you a better investor without having to find just the right investments to own.

The critical insight is to understand your relationship with risk. How well do you tolerate it? Can you afford to take it? How will you respond when risk confronts you head-on in your account balance?

Many investment education programs and financial advisors will suggest evaluating your risk tolerance by answering hypothetical questions or questions about how you have responded to investment outcomes in the past. Understanding tolerance might help you gauge your willingness to accept unknown outcomes in exchange for the possibility of a future return on your investment. That is a relatively unchanging measure.

Risk-tolerance evaluations do not help you understand your capacity to accept risk. Whether or not you can afford to accept risk is a function of the size of your investment assets, your income sources, age, your expenses … a variety of things that do change over time, making risk capacity a variable factor that needs the attention of a thorough and ongoing financial plan. Given the strength of stock market returns in 2021, your capacity to accept risk in your portfolio might have changed entering 2022. Your tolerance for risk might also have strengthened. People tend to see investment markets being less risky as they are going up and riskier when they are trending down, when, in many ways, the opposite is true.

If your capacity to take on risk has increased and you are tolerant of it, that still doesn’t mean you should turn up the risk dial on your investments until you understand the third component of your relationship with risk.

You can be comfortable with your risk tolerance and capacity and still have both overwhelmed by what psychologist and behavioral finance author Daniel Crosby calls your risk composure. It is at extreme moments in investment markets, both to the good and bad as fear and greed become influential, that you need to understand how the emotional element of managing your life savings influences your decisions. If you have low composure, you might be susceptible to not sticking with your investment strategy during times of stress or times of excess. The best investors have high composure amid the constantly shifting landscape of investment markets, the global economy and personal factors that impact financial security.

If you know that you are susceptible to low-composure moments, especially if you also have low capacity to take risk, you can design an investment portfolio (or work with an advisor to do so) that limits the likelihood that you will find yourself in moments where you are tempted to choose a different path, possibly at precisely the wrong time.

The investment industry commonly communicates about risk-adjusted returns when trying to optimize the risk/return profile that is the best fit for any particular investor. What might be more useful, according to Crosby, is anxiety-adjusted returns. If you can design and implement an investment strategy that can reduce exposure to stressful periods where risk becomes more evident, you’ll be much more likely to stick with your strategy.

Even if you sacrifice some return potential in exchange for less anxiety, you can build wealth. The magic of compounding returns is not so much achieving periodic exceptional performance from your investments but simply sustaining even average performance for a long period of time. As Howard Marks has written: “That’s not to say good returns don’t matter. Of course, they do. Just that they matter less than how long your returns can be earned for. Excellent for a few years is not nearly as powerful as pretty good for a long time. And few things can beat average for a very long time. The only thing that matters is where you are in the long run.”

Make 2022 the year that you commit to a documented financial plan and investment strategy that incorporates an intentional assessment of your personal risk characteristics. Rather than continuing an eternal search for investment winners that can overcome your investor behavior, consider reading “The Psychology of Money” by Morgan Housel or “The Behavioral Investor” by Crosby. You might gain knowledge about yourself and your relationship with money that helps you manage key life transitions over time.