The market crash of 2008 has left many people wondering why they should bother investing at all. 401k balances were devastated and their dreams of retirement felt out of reach. For some, dreams actually turned into nightmares. The bad taste has had a prominent affect on our future outlook to investing. So how does risk tolerance play into this and why is it important? The importance lies within your fight or flight response.
Keeping Your Emotions in Check
Each individual has a certain pain threshold and this holds true with investing. Your risk tolerance is the point at which you can you no longer take a stock market downturn and move your money into cash. We all have a tipping point and it is important to find it. Keep in mind that this is an emotional behavior and not your capacity for risk. Let me explain. Capacity for risk is your financial capacity to withstand market losses. For example, if you are a high net worth individual living with modest means then you would have a high capacity for risk during a market downturn. You would have enough assets to live off of during this time period. Your risk tolerance during this period would be how you slept at night and thus an emotional behavior.
Ok, so stay with me here. Risk tolerance is an important concept because your behavior will help determine what kind of returns you will get. The worst thing you could do is build a portfolio of all equities (100% invested in stocks) when your tolerance for risk is half of that. Essentially, you would have sold during a downturn hampering any gains you might of had. If you had a portfolio of half equities and have fixed income (bonds & cash) then you might have stayed in the market and reaped the benefits of a market rebound. You may say to yourself that you’re a better investor then that and would have held strong. Well, we all have short term memories but during the time from October 2008 to mid March of 2009 many people were saying the sky was falling and it felt like it too. As investors sometimes we allow our emotions to get the best of us. Dalbar, Inc. is a company that compares investors market returns vs. the S&P 500 index. For the last 20 years ending in 2012 the S&P 500 had a return of 8.21% while the average equity investor earned a return of only 4.25%. For many of us the market can trigger a fight or flight response, so you must decide how comfortable you can sleep at night during your worst case scenario.
How do you go about determining your risk tolerance and thus a suitable portfolio? Well, this isn’t an easy question to answer. As an advisor, we must consider your goals and your individual situation to determine what portfolio is suitable for you. Someone with a high risk capacity and high tolerance for risk might not need an aggressive portfolio if their goals are within reach. If you decide to manage your investments on your own, you may find it helpful to do the following. First, find a questionnaire to help you define what your tolerance will be. If you google ‘risk tolerance questionnaire’ you will find many other options but keep in mind that each company will tailor the results so that you will invest in their funds. Next, write a letter to yourself. In the letter (similar to an investment policy statement), tell your future self about your objectives and outline how and when you should rebalance. An example of this might be to rebalance when you’re equities are more than 5% of where you started from or rebalance on an annual or quarterly basis (this is not a recommendation but serves only as an example). The letter will help you stay the course when your emotions are getting the better of you. It also creates an environment where you are buying low and selling high.
Filling out a risk tolerance questionnaire won’t guarantee you’ll sleep better at night but it will provide you a basis of what you can withstand.
[photo courtesy of snowlepard]