As anyone would have expected, the extraordinary convergence of extreme stock market volatility, low interest rates, declining home values, diminished retirement savings accounts, and chronic economic sluggishness has taken a severe toll on the American psyche. For many investors, it may have forever altered the way in which risk is perceived and managed. For those who misunderstand their actual tolerance for risk this could result in the long-term underperformance of their portfolios. Understanding your risk tolerance is one of the most important elements of investing; knowing how your risk tolerance affects your investment decisions is vital to the health of your portfolio.
Risk tolerance is most commonly understood as a measure of one’s financial ability to withstand losses. On the risk-reward continuum, the more risk one takes, the greater the reward should be expected, and vice versa. Typically, a linear equation is applied that seeks to find the level of risk a person should be able to withstand when seeking to achieve a certain return. For example, an investor who can withstand a 25 percent loss in his portfolio value without it affecting his ability to meet his long-term goals may be able to invest more aggressively in an effort to achieve potentially higher returns than someone who couldn’t afford to lose more than 10 percent. The financial measure of risk tolerance is a function of several factors including your time horizon, income, liquidity, and net worth. Generally, the more of each an investor has the more risk he should be able to take because of the greater capacity to recoup losses.
Less understood is the emotional (and deeply personal) aspect of risk tolerance, yet it can have far more influence over investment decisions than the clinical financial components. Emotions are far more powerful than logic and can drive investors to make decisions without regard for their long term financial implications. The two emotions that can be the most devastating to investors are fear and exuberance, and both can be triggered through the irrational behavior of a reactionary crowd. It’s what leads investors to sell the stock market en masse after it has already fallen by 30 percent; and it’s what draws investors into a spectacular market rally near its peak. In both instances, investor risk tolerance is skewed by emotions which often results in investment decisions that bear no reflection upon their long-term investment strategy.
Still, emotions are important element in risk tolerance when they are understood. Fear breeds caution which can be a useful attribute to successful investing. But realizing that emotions are reactionary mechanisms that tend to drive decisions based on short term events, may help investors keep them in check when viewed in the context of a long-term investment strategy. It would be hard not to lose some sleep when the stock market experiences poor short term performance. But a few uncomfortable nights are not damaging to your investment performance. However, for those investors who react with short sighted and often emotional decisions with their intended long term portfolio, the permanent impairment of capital is the likely result.
Generally, investors who focus only on the markets tend to experience a roller coaster of emotions and their confidence is more inextricably tied to their performance. Conversely, investors who stay focused on their long-term investment strategy need only to have confidence in the strategy. If it’s well-conceived with thoughtful diversification and well-managed through proper rebalancing and adjustments for an evolving risk tolerance, the confidence is well-justified.
(There is no assurance a diversified portfolio will outperform a non-diversified portfolio. Diversification and rebalancing do not assure a profit or guarantee against loss.)
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