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Why Investors Can’t Measure Their Own Risk Tolerance

Why Investors Can’t Measure Their Own Risk Tolerance

Why Investors Can’t Measure Their Own Risk Tolerance

When people start investing money, one of the exercises they engage in is determining their own risk tolerance.  Usually, this process is handled by filling out some sort of questionnaire that has multiple choice questions like the one below.

‘If you had $10,000 to invest, would you….’

  • Be willing to chance earning 30% growth knowing you could lose 30%
  • Be willing to chance earning 10% growth knowing you could lose only 5%
  • Be willing to lose nothing knowing you could earn no more than 5%

We often whisk through these quizzes at a blazing pace because in a simulation exercise we know exactly who we are.  However, there are two types of behaviors that we have within our personality.  How we act in a natural state when we are relaxed and have no pressure.  Then, there is the adaptive state when we are under heavy pressure.  Unfortunately, these quizzes don’t really put us under any pressure so they don’t really tell us how we would react when markets are in a roller coaster state.

With the Dow having two 1,000 point drops over the past week and fielding tons of investors called, it reminded me that investors truly do not know how to measure risk.  Measuring reward is easy.  You can clearly see if your 401k is up 20% or down 20% by just opening up your statement and seeing it on the front page.  The number that you don’t see is the risk that it took you to get to 20%…until the markets start to turn due South and that is when you turn to the state of panic.

The Dow Jones Industrial Average Index didn’t have a single down month in 2016.  Not one.  The two main emotional drivers in the stock market are GREED and FEAR.  So, when the markets are going up month after month without any sign of slowing down, our cheshire grin of greed is secretly getting larger as we see our statements grow every month.  It’s funny, because nobody ever calls up and asks, “Ted, how much did we make today?” or “Ted how much are we up this week?”  When the markets are climbing, people just sit back and enjoy what’s happening without hardly any questioning at all.

This is why there is no doubt that FEAR is a much more stronger emotion than GREED.  Perhaps three or four times larger in my opinion.  The moment that investments start to turn south, everybody wants to know “What’s going on?” and “Is this going to continue?” even though the loss may only happen over a few days and not even months or years.  FEAR is the real driver that can tell you what your real risk tolerance is because when the roller coaster hits its first large drop you will really know whether or not you are ready for the ride.

You may think you know how risky you really are and you may be able to answer it in a natural state, but how did you really respond over the past week.  If you were too nervous to log in online to see how things did or too nervous to even turn on the television, maybe that should tell you a thing or two on how risky you really want to be.  Just because you don’t shoot for double digit returns doesn’t make you a bad person, it just makes you the investor that you really are when you put your money on the line.

Happiness is about expectations met or unmet.  If you want to be a happy investor, take a look in the mirror and decide what kind of investor you want to be.  Don’t take the losses out on your friends, your family, or your advisors because you don’t know what kind of investor you want to be.  Get a real understand on how you want to invest your money with both risk and reward, and you’ll be a much happier investor for the long haul.

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