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Understanding Risk Tolerance in Investing: Avoid Costly Mistakes

There is risk with anything in life. When we get into our car to drive to work, there is a risk of an accident. When we play sports, we risk getting hurt. And when we invest, we risk losing money. Because there is risk involved, we have to understand what our risk tolerance is before we decide to do anything.

Talking specifically about investing, it is critical that you understand how you handle risk if you want to be a successful investor. If you ignore this step of the investing process, you will lose money and think the system is rigged against you.

So today we are going to get a complete picture of risk tolerance so you can make smarter investing decisions based on how much volatility you can handle. In the end, this will help you on your path to becoming a successful investor.

Definition Of Risk Tolerance

Risk tolerance is defined as the amount of variability in investment returns that you are able to withstand. In other words, it’s how much wild swings in the stock market you can handle without staying up all night, biting your fingernails and worrying. Or worse, selling everything and stashing it under your mattress. It is important to accurately determine your risk tolerance because if you don’t, you risk not meeting your investment goals.

For example, let’s say you take on too much risk. This could mean you invest too heavily in stocks or that you simply chose more volatile stocks to invest in. In this case, your portfolio swings wildly up and down with the market. If you cannot handle this, it will take its toll on you emotionally and possibly even physically.

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As a result, you are going to sell out of the market, most likely at exactly the wrong time. You will be jaded about the stock market and will not re-enter until the market swings back to the top or worse, never invest again.

On the flip side, you might take on too little risk for your tolerance. This could mean you invest too little of your money in stocks. As a result, you won’t be earning the returns you need. Over time, you will realize that your portfolio is not growing as it should and the end result will be not having enough money for a secure retirement.

When faced with this situation, instead of slowly changing your allocation to a more aggressive one over time, too many investors overreact and take gambles they should not in order to make up for lost time. This again leads to bad experiences with the stock market. If you are curious to see what type of investor you are, click here to find out.

Keeping Risk In Perspective

One flaw that most investors have is letting their emotions make decisions for them. This happens when we don’t put risk into perspective. For example, many investors fled the stock market back in 2008 after the collapse. Many have not returned.

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They are too scared, thinking they will just lose money again. While there is a good chance you will lose money over the short term, over the long term, the picture changes.

In the picture below, you see the annual returns of the S&P 500 Index since 1928. The green boxes are the years of a positive return, and the red boxes are negative returns. Notice how the green boxes outweigh the red?

In fact, 65 times the market had a positive return in those 89 years. That is a 73% chance of making money. But too many investors focus on the recent past.

We need to put things into perspective. Too many times we fear things we shouldn’t and don’t fear things we should. For instance, many people fear flying. But you have a 1 in 7,000 chance of being in a plane accident. On the flip side, we don’t fear driving. But you have a 1 in 303 chance of being in a car accident.

Many people still get married every year even though close to 50% of marriages end in divorce. So why do we not fear risky things but fear things that are not risky?

There are a few reasons.

Emotion over fact: Our emotions are powerful. All too often, we discount risk or overestimate it simply because of emotions. This is why so many fear flying even though it is safer than driving. And it is why people who were burnt investing back in 2008 are afraid to invest again.
Short-term pleasure too good:If the short term pleasure is great enough, we ignore the risky behavior. This is why people kept buying houses in 2007. They thought it was an easy way to get rich fast, ignoring the risk involved.
Perception: Based on our perception of things, we discount risk. For example, if I told you there was a 40% chance of snow today in both Denver and Dallas, you believe that you will more likely see snow in Denver, simply because it is perceived as a place that gets snow more often.

Luckily there are some ways for us to put our investing risk tolerance into focus so that we make better choices based on the risks involved.

The Importance Of Risk Tolerance Questionnaires

Before you enter into an investment, your advisor should provide you with a risk tolerance questionnaire. This short multiple-choice document will assist you in determining your correct risk tolerance. Therefore, it is extremely important that you answer the questions truthfully and take your time to fully understand them.

If you handle your investments on your own, you should still seek out a risk tolerance questionnaire to complete so that you know how you should be investing.

Vanguard offers an excellent risk tolerance questionnaire for you to use. As you take the quiz, you will see that many factors go into determining your risk tolerance. If you answered the questionnaire honestly, you should be left with a risk tolerance that allows you to meet your long-term goals while at the same time allows you to sleep at night.

The Problem With Risk Tolerance Questionnaires

While the idea of risk tolerance questionnaires is great in theory, many of them fall short. Too many of them rely on time horizon as the deciding factor. For example, if you answer the majority of the questions by choosing the least risky answer but say you have 20 years to invest, most will default to giving you a portfolio that is too risky for your risk tolerance.

Ideally, these questionnaires should more heavily weigh the likelihood of you moving your positions to cash when the market drops. This is a good indicator of the level of risk you will tolerate.

Additionally, investors tend to focus on losses more than gains. This is because no one wants to lose money. My advice when filling out a questionnaire is to focus more on the questions that ask about your tolerance for losing money. After all, everyone would love to have a 25% gain, but are you willing to lose 15% for the opportunity to do so?

Just so we are clear, I played with the Vanguard questionnaire that I linked to above and found that it does a good job at weighing all factors equally, which is why I am recommending it.

Some investment sites, like Betterment, avoid the questionnaire altogether because they feel investors don’t answer based on their true risk tolerance. With Betterment, you pick your goal and they select the asset allocation for you.

You can always adjust it if you like, but they are good at choosing the right allocation for you. If you are into a more hands off approach when it comes to investing, you should definitely look into Betterment.

Final Thoughts

No matter how comfortable you are with risk, you will still be tempted at times to pull out of the market because of the volatility. Understand though that this volatility occurs over the short-term and that by riding it out and not overreacting by selling out of your holdings is the best solution.

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Do whatever you need to do to turn your attention away from the market. At the very least, pull out your investment plan and your risk tolerance questionnaire to remind yourself why you are investing in the first place. Doing this will help you to avoid making the common investing mistake of not buying and holding for the long term.

If you want some more help with investing, check out my ebook, 7 Investing Steps That Will Make You Wealthy.