What is risk tolerance? It’s your ability to deal with investment losses … usually in the short-run … to have the chance of earning higher long-term returns than you would get in a bank account.
– On the one hand it’s about how much you can afford to lose.
– On the other hand, it’s also about how much money you can emotionally tolerate losing.
It’s extremely important to your success as a long-term investor to know your tolerance for risk. It’s a key part of designing an investment program that is appropriate for you and for picking individual investments.
What You Can Afford to Lose: An examination of your individual circumstances is required to figure out how much of your nest egg you can afford to lose in the short-run on investments that promise to deliver attractive growth in the long-term. But there are some general guidelines:
– Generally speaking, the more years you have until retirement, the higher your risk tolerance should be.
– Conversely, the more likely you are to tap into your nest egg early, the lower your risk tolerance should be.
The Emotional Aspect of Dealing with Risk: Studies of investor behavior show that emotions are a significant contributor to poor, long-term investment performance. Investors tend to get stuck on an emotional roller coaster that leads to poor investment decisions. Here is what the roller coaster ride often looks like:
– Investors get excited about investments that have already gone up and buy near the peak in value. When prices drop, investors find it emotionally difficult to accept and will rationalize holding on until prices improve. Then the bottom drops out and investors sell near the bottom, no longer able to cope with the anguish. Emotionally battered, they find it difficult to reinvest near the bottom and end up missing the next move up … only to reinvest later on after values have risen above where they had sold (buy high … sell low?) Then values peak once again, prices drop and the cycle continues.
Sound like anyone you know? This is why sticking with a disciplined investment plan is so important to successful investing. Overcoming your natural emotional reactions driven by fear and greed is the key. But that is hard to do.
– It becomes harder the more risk you accept in your investment plan.
What Percentage of Your Nest Egg Can You Lose? Before designing an investment plan, it is helpful to think about your risk tolerance in terms of a percentage. For example, you might say “I am willing to see my portfolio decline as much as 12% for a period of time if it gives me the opportunity to realize better growth over the long-term compared with leaving the money in a risk-free bank account or CD.”
– Perhaps you could tolerate losing as much as 30% of your nest egg temporarily investing in something you thought could earn you a long-term growth rate as high as 10% to 15% per year.
Build a Disciplined Plan Around Your Risk Tolerance: No matter whether you’re a big gambler or a scared chicken, knowing your risk tolerance expressed as a percentage should make it easier for you and/or a financial professional to design an investment program that isn’t likely to push your emotional hot buttons.
– If the inevitable volatility of your investments remains within your emotional limits, you will be miles ahead in the long run simply from having been able to stick with a disciplined strategy.
You and/or a financial advisor can compare your percentage risk tolerance to the historical volatility (annual standard deviation) of different types of investments and design portfolio allocations that will more likely meet your long term investment objectives while staying within your risk limits.
Calibrate a Mechanical Investment Strategy to Your Risk Limits: With the use of computers and mathematically-based investment strategies, it is now possible to calibrate a mechanical investment strategy to your maximum risk tolerance.