I’ve already mentioned in a few posts that it’s vital to have an asset allocation that matches your time horizon and risk tolerance. Figuring out your time horizon is simple enough, but things get a little more difficult when it comes to assessing your risk tolerance. Some advisors will point you to a standard questionnaire that is suppose to measure your ability (or inability) to handle risk. The problem with these quizzes is that they try to measure an individual’s emotional response to varying scenarios with intellectual questions. How you respond to a question about a hypothetical portfolio loss of 50% is probably quite different then how you actually responded last year when the markets were plummeting day after day.
The following article examines how the best gauge of risk tolerance is actually the level of composure one has when something unexpected occurs: Tune In, Chill Out
“People say they’re willing to lose 20%, then they lose 2% and they panic. A more meaningful indicator is composure — your short-term, emotional reactions to unpredictable and uncertain events, such as the market’s ugly sell-off on Friday. How will you handle yourself in the heat of battle? Far too many investors discovered in 2008 and early this year that losing money in quick, sharp cuts was more than they could bear. Those thoughtful risk-tolerance quizzes got shredded when stocks went into free fall. Panicked investors sold what they could, often at any price.”
Some comments on Buffett’s, “Be fearful when others are greedy, and be greedy when others are fearful” quote…
“There’s a good reason why there aren’t more Buffetts among us: Buffett is not only more risk tolerant, he’s more composed. When the shooting starts and money is on the line, Buffett comes across as cool and unemotional. And he fires back. Think Clint Eastwood with a calculator.”
On how you can increase your composure…
“First, commit to an investment policy with a long-term or big-picture focus that recognizes there will be major pitfalls along the way. This is your battle plan. The most effective policy statement lays out objectives. These include return goals — how much money you’d like to make — and the potential obstacles to that happy outcome. In this way, you get a sense of how emotions dictate your actions.”
“Second, divide your wealth into different mental accounts with varying degrees of risk. Investors should not be diversifying asset classes; they should be diversifying risk.”
That is an excellent way to look at it, especially since chances are good that many people have faced an emergency or stressful situation before, so they can look back and see how they acted in reality instead of basing things on how they THINK they might act and feel.
Hi Jackie, that’s exactly what they’re talking about. It makes sense… if you’re extremely emotional and get upset at things easily chances are you’re going to panic when the markets dropping. Thanks for the comment!
I do highly subscribe to dividing your wealth into various mental accounts. It’s all about NOT co-mingling funds.
My trading account, for example is a good one, where I start the yr, every yr with 50K. I’ll leverage it 3:1, whip it around, and at the end of the year, see how it performs. If i lose it all, it would suck, but it’s in a different mental account and is not counted towards retirement. I just want that money to be ready one day if i see something so good, i can drop some money in it and watch it be a multi-bagger. Ya never know!