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People always say you should split your investments among equities (such as stocks) and fixed-income (such as bonds) relative to your age and risk tolerance.
There’s no question when it comes to the “age” part of the equation; we all know how old we are. But how do you determine your risk tolerance?
That’s the million-dollar question … literally.
During the recession, plenty of people who thought they were highly risk-tolerant discovered they really weren’t. They panicked when their portfolios fell and sold their holdings, turning paper losses into real losses, missing the ensuing recovery, and learning a very expensive lesson about the importance of knowing your real risk tolerance.
Let’s save you some money (and stress) by going over some of the ways you can determine your risk tolerance—before it ends up costing you.
Long-Term Investment Vision
Your first clue to how risk-averse you are comes from your overall vision for your investments. If you don’t have a real, long-term strategy and are just “seeing how things go,” you may fall on the highly risk-averse side of the spectrum. You’re likely to be swayed by the smallest fluctuations – the hype and drama — and don’t have the long-term planning necessary to ride out the natural ups and downs of the market.
If, on the other hand, you’re “in it for the long haul” (meaning 15 years or longer), you’re on the risk-tolerant side of the spectrum. You have a strategy for your investments and are confident about your plan, and this allows you to observe market fluctuations without getting nervous and making any hasty decisions.
Response to Market Fluctuations
If you’re the sort who’s poised to cut and run the instant your funds take a dive, it’s a good indication you’re highly risk-averse. You’re not ready to weather the ups and downs of the market and feel every crash as a punch to the gut. You feel personally connected to every dollar in your portfolio and see losses not as a natural part of the investment game, but as a robbery of all the hard work and effort you put into earning that money.
If you were more risk-tolerant, you would recognize that market fluctuations are par for the course when it comes to investing, especially if you’re playing a long game that spans 15 years or more. While you certainly don’t enjoy losing money, you have faith that your strategy is smart and you will recoup that loss down the line. You recognize that your dollars are working for you now, and you need to let them do their job in their own good time.
Obsessive Balance-Checking
When did you last check your balance? Six months ago? One month ago? About an hour ago, and you’re itching to check it again?
Risk-averse people keep an eagle eye on their balances because they’re not sure of their investments and don’t have the wherewithal to endure any large shifts. Unfortunately, monitoring your balance’s every move won’t really do much to add to your bottom line; in fact, it can actually hurt you because you’re easily swayed by momentary changes and won’t allow your funds the time they need to recover—and ultimately grow.
Risk-tolerant investors rarely check their balances. They’re secure in their strategy and recognize the market will shift, many times, over the course of their investments. Their focus is on the end goal, not all the little losses and wins along the way.
Listening to the Media
Risk-averse investors might keep the majority of their assets in “safe” investments like cash, bonds and gold, due to their fear of loss. While having a higher exposure to these types of assets makes sense for a 50-something or 60-something, this can actually be harmful to a younger investor.
On the other hand, risk-averse investors may “defer to experts” to tell them how to invest. This absolves them from needing to think about it themselves.
Unfortunately, many may rely on “expert” advice from media gurus like Mad Money’s Jim Cramer. They devour stock market TV shows, magazines and blogs because it gives them that sense of security they crave—they don’t trust their own decisions, but if the talking heads recommend a course of action, then clearly it must be right.
The trouble with this is that most of this media coverage focuses on advice for day-traders and touts rapid buying and selling, which can only make you feel more nervous about the state of the market and your investments and won’t lead to much steady, long-term gain.
The risk-tolerant recognize that the media feeds on “breaking news” and big drama. They rarely (if ever) consume media advice about investing because they’re on their own path and feel confident in their decisions.
Listening to Personal Stories
People love giving unsolicited advice, especially when that advice involves sharing their own shocking horror stories. But investment horror stories are like dating horror stories; many people have them, but that doesn’t mean we’re all doomed.
You know very little about other people’s portfolios. The things that led up that bad investment decision or horrible loss could tell a totally different story than your neighbor, who casually told you over the fence to “never hold money in a down market.”
If you believe you’re on the right path, don’t allow yourself to be swayed by what has happened to other people. If you listen to anyone when it comes to your investments, let it be a trusted and respected financial advisor whose job is to guide people in these matters. Anyone else’s advice isn’t worth your time.
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