What is Your Real Risk Tolerance?
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To my female readers, pardon the expression, but it is aggressive bear markets that separate the boys from the men. The conviction to hold to a solid investment plan (such as a dividend growth plan) is the cornerstone of good portfolio management and amateur investors typically fare very poorly. I have been thinking about why this is a lot lately and the reason I have come up with is that many investors do not really understand what their true risk tolerance is. I have spoken with many investors at work, with friends, family, etc. and many have made emotional decisions without considering the true facts. To be a successful investor, it is important to determine a risk profile for yourself that will not allow emotions to determine your actions.[ad#tdg-embedded]
Here is the scenario we have all been through. The global economy is tanking. Oil is down and with it many large companies are heading lower. The financial crisis is sending the banking industry into the tank and with it stock prices. Credit is tightening and loan providers are making it much more difficult for people to get access to money. As a result of this, consumers are sitting on their hands not spending as much money sending consumer companies down the tubes. Things look bleak and it feels like the world is coming to an end! How do you feel as an investor? Pretty crappy right. You see your portfolio crashing and all the money you have lost and it is stirring up thoughts and feelings that do not feel very good. The desire to act on these is overpowering. You sell everything and “feel” better. Problem solved right…
I do not think so – in this scenario emotions are the enemy and have caused many investors to make stupid and irrational decisions. And I believe it could have been adverted if investors knew their true risk tolerance. Being too aggressive in your portfolio (e.g. 100% equities) exasperates the above scenario because the losses add up even quicker. When markets are going up
So what should you do – go back and complete a couple of risk tolerance assessment tools again and really answer them honestly this time. Do not allow over-optimism to cloud your answers. Answer honestly and thinking about the absolute worst case scenario. Here are some tools you can start with:
ING Financial
WalletPop
Investopedia
Keep in mind, I am not suggesting an investor goes too conservative. This can be bad as well as you are giving up the possible gains when the market does turn around. However, emotional reactions can be far more devastating than a portfolio that is too conservative so really be sure you can stomach a crashing market (and portfolio value).
(Thanks vicbuster for the pic)
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8 Comments on this post
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Marianne O said:
A good point. The really risk-tolerant would have only one thing to worry about when the markets tank — where to find the cash to buy MORE stocks while they’re cheap!
By the way, I think you mean “exacerbates”, not “exasperates.”
Cheers
January 14th, 2009 at 1:15 pm -
Dividend Growth Investor said:
That’s a very good article TDG. I agree that I feel comfortable holding a 25% fixed income allocation and dollar cost averaging in a position. I am more comfortable losing little with lower upside potential rather than win big, but potentially lose big ( or lose it all).
Of course having a diversified dividend income portfolio really smooths out your returns over time..January 15th, 2009 at 12:57 pm -
Mark said:
Good article. I have a very high risk tolerance so I typically allocate 90 percent of my assets to equities. I try to only buy equities that pay dividends to provide some income.
January 15th, 2009 at 1:56 pm -
Bootstrap said:
I agree with your comments. Unfortunately the concept of risk is too often glossed over as a concept in investment managment. I’ve written a couple of posts recently on the same subject as it has been on mine (and readers) minds!
January 26th, 2009 at 1:33 pm
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