Understanding Your True Risk Tolerance

Christopher D. Flis |

The recent stock market volatility, the bear market, the inflation rate, and ongoing supply issues have taken a severe toll on the American psyche. For some, it has forever altered how they perceive and manage risk.

Understanding your risk tolerance is considered one of the most important elements of investing.

Many people see risk tolerance as a measure of their financial ability to withstand losses. In theory, the more risk you take, the more potential for reward, and more potential for loss. For example, a person who can withstand a heavy loss in their portfolio without it compromising their ability to meet their goals may choose to invest more aggressively than someone who has a lower tolerance for loss. There are several factors to consider when determining your risk tolerance including income, net worth, liquidity, and time horizon. A financial professional can help you assess your situation and determine a level of risk that’s suitable for you and your goals.

Emotional Risk Tolerance

The emotional component of risk tolerance can have far more influence over your decisions than your financial capacity. Emotions are powerful enough to override logic and can drive people to decisions that may not be aligned with their overall financial plan. The main emotions to be mindful of are fear and exuberance; both can be triggered by the irrational behavior of reactionary crowds and media. This response is powerful enough to lead people to flee the stock market en masse after it’s already fallen and draw people into a raging market near its peak. In both scenarios, individual risk tolerance is being skewed by emotions, which leads to divisions that do not reflect their long-term strategy.

Emotions are an important element of risk tolerance and shouldn’t be overlooked. Understanding that emotions are reactionary mechanisms that tend to flare up over short-term events may keep you in check when looking at the context of your long-term strategy. It would be hard to not lose sleep if the market suddenly crashed. It’s a natural human response. But, realizing that, you don’t have to act on those sudden emotional responses, especially if it works against you in the long run.

Consider your Time Horizon

What's often reported in the news is a reflection of short-term market volatility and trends. However, for those who have a longer timeline until a drawdown is needed, it may be helpful to look at historical trends of the market. For an example for military service members and government employees based on Thrift Savings Plan, check out Actually Staying the Course. If your plan is well-balanced, diversified, and managed through proper rebalancing for evolving risk tolerance, short-term market events may have less impact.

If your time horizon is shorter, your strategy should adjust to buffer your risk to what's appropriate for you. What that entails is unique to your situation. For instance, those with a reliable, inflation-adjusted pension may be able to handle more risk considering that their pension can serve as a counterbalance to market volatility. For others, capping their downside through insurance policies or other financial or risk-mitigating vehicles could be a better approach. 

Are you at the Right Risk Tolerance (for you)?

One of the best ways to determine if you're at about the right amount of risk for your current situation is the sleep test. Are you having trouble sleeping or waking up in the middle of the night worried about your financial situation? If so, it's likely time to do some reflection and, potentially, to adjust your financial picture so you can sleep soundly. Some things to consider:

  • Dig deep for a root cause: Is there a specific issue that is concerning you? If you're worried about the performance of an individual stock, or the amount you have invested in a certain asset class, there's more to uncover there. 
  • In tandem with the above, is there an emotional anchor that may be magnifying your fears? Seeing a parent struggle during their retirement, or hearing about a friend lose their job can impact your own perception of security. 

Once you find the stress point, it's time to brainstorm possible solutions. Perhaps it's time to build or beef up your emergency savings in the case of a recession or if you're worried about company layoffs. Maybe shifting to diversified index funds and out of those individual stocks will help you sleep better at night. Or perhaps you want to get a second set of eyes to help spot check and validate your financial plan going forward. 

Math can Help

In the face of uncertainty, sitting down the facts and running the numbers can help tremendously in easing emotional unease and anxiety. If you would like help in running the numbers and building or fine tuning your financial plan, contact us to set up a free, no-obligation consultation to see if we're a good fit.