Assess Your Risk Tolerance
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“Risk comes from not knowing what you’re doing.” Warren Buffett
I’ve been investing for many many years. In my 20’s all I could think about was “the great depression” and how so many lost so much. Although I had a Bachelor of Science degree in Economics and had taken a class or 2 in the stock market, I was scared of stock investing. I was terrified of risk and I certainly didn’t know much about investing.
As I acquired some cash, I went to visit a stock broker who respected my preferences and introduced me to some bonds and bond funds. He introduced me to the dollar cost averaging and answered my investing questions by loaning me his investing training manuals. After dipping my toe in the investing pool, learning a bit about investments, and watching my net worth grow for a while, I gained some confidence. A lifelong passion was born.
MAIN TOPIC; Risk tolerance THEN and NOW
Although my investment portfolio went up and down, I got used to the volatility. I was still afraid of “losing it all,” but learned through study, that if I diversified my assets, the ups and downs of my portfolio would even out. I didn’t know it at the time, but my RISK TOLERANCE was governing my investment decisions.
For those of you just starting out, or learning about investing, start with introspection. When your investment value goes down 10-15%, are you a nervous wreck? Does this small percent drop in your portfolio terrify you and keep you up at night? If so, you need to titrate your portfolio to honor your temperament.
WHAT THE HECK DOES THAT MEAN?
Riskier assets with more ups and downs usually offer HIGHER RETURNS.
Stock investments: Individual stocks, stock mutual funds, international stocks offer the possibility of greater returns along with more risk.
Bond investments: Individual bonds, bond funds, corporate, and government bonds offer lower returns and less volatility.
SOUNDS SIMPLE; JUST INVEST IN STOCKS, GET HIGHER RETURNS.
OR – SCARED OF RISK? INVEST IN BONDS AND ACCEPT LOWER RETURNS.
Wait a minute, not so simple.
These investing maxims have held up over the long term IN THE PAST; but what about the last 5 years? According to Morningstar.com, during the last 5 years, bonds outperformed stocks by a large margin.
5 YEAR RETURNS-annualized
Morningstar US Market Index-0.67%
Morningstar Core Bond Index-6.04%
Practical Application: What should I do?
Are you totally confused? To summarize, long term stocks offer higher return with more risk; bonds have lower returns and lower risk. But in the past 5 years, stocks had high volatility and low returns and bonds outperformed stocks by a huge margin.
Welcome: DIVERSIFICATION
Those rules of risk and return have held true in the past over the long term, > 10 years.
NO ONE KNOWS WHAT TYPE OF RETURNS AND VOLATILITY THE MARKETS HOLD IN THE FUTURE.
Protect your investments by spreading around the risk.
During the past 5 years, if your investment portfolio looked like this:
50% STOCKS
50% BONDS
Your annualized return would have been 3.36% with moderated volatility.
The lesson is to choose investment funds in a variety of asset classes. The ups and downs will balance out and moderate the returns and risks.
Conventional wisdom recommends a greater percent of your investment in stocks if you are younger and can tolerate more risk. If you are older and/or more risk averse, raise the percent of bond assets.
Continue reading this series and you will learn how I invest our family assets.
BEFORE YOU INVEST YOU MUST READ 10 STEPS YOU MUST TAKE BEFORE BEGINNING AN INVESTING PROGRAM.
Caveat: This article is for information purposes only and may not be appropriate for your individual situation.
ACTION STEP:
Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it to keep all of your personal finance goals, thoughts, activities, and plans.
Take a RISK TOLERANCE QUIZ or 2 and jot down whether to weight your portfolio more toward stocks or bonds.
MSN Money Risk Quiz
Risk Tolerance Quiz from Rutgers University site by 2 finance professors (Source: Grable, J. E., & Lytton, R. H. (1999). Financial risk tolerance revisited: The development of a risk assessment instrument. Financial Services Review, 8, 163-181.)
image credit; purplemattfish
RECENT PERSONAL FINANCE CARNIVALS & Link Round up
I am honored to have my work showcased at these sites recently. Why not stop by & check out the fine articles?
How to Design a Budget with Room for the Fun Stuff was selected for a link round up at KNS Financial
Carnival of Money Stories at Eventual Millionaire published No Brainer Money Management for College Students
Carnival of Wealth at Personal Dividends posted Follow these Instructions and Get Wealthy
YAKEZIE PERSONAL FINANCE BLOGS
After every article for the next several weeks, you will be introduced to several Personal Finance web sites in the Yakezie network. Each one has their own unique voice and style. The consistency in all is their desire to help others. Consider visiting a few each day!
My Personal Finance Journey
Narrow Bridge
Not Made of Money
One Money Design
Out of Debt Again
Parenting Family Money
Peak Personal Finance
Personal Finance by the Book
I appreciated how you mentioned reviewing your own risk tolerance and it sounds like you had a good stock broker who heeded your concerns. I recently was reading where the author recommended dividend stocks from major companies like P&G for the timid investor. Do you agree?
My financial advisors did a great job discussing and helping me figure out my risk tolerance. But when your strapped in that rollercoaster ride and your feeling that exhilaration when your portfolio goes up and that sick feeling when it goes down, sometimes your risk tolerance goes out the door. I think for some, you must find your risk tolerance and then set it a little lower. When your sitting in your financial advisors office all nice and cozy your feeling a little bolder than normal. I’m just saying.
I totally agree with you – some of the old rules seem to be broken right now. Sure you can go back 80 years and stocks would still beat bonds in overall return. However, who knows what the next 80 years will hold? You could think ‘stocks are low, so now is the time to dive in’. Or, you could think ‘stocks are low, I don’t trust them.’. It is hard to decide because our economy is changing. The US used to dominate and now we have much more global competition. I personally have been very heavy in stocks in the past, but I have been making some modifications to increase my bond holdings in my 401k.
Decisions, decisions!
Great point about risk tolerance. Ultimately, valuation plays the biggest part in determining your returns. However, that takes work, so you either have to spend the necessary time or pay someone to do it.
If you have the time to do light research and calculations, I would not recommend extensive diversification – tends to dampen your returns. But, if you don’t have the time, it may be your only option.
Also, thank you for including a link to my article. And the quiz from my alma mater/employer! lol
@Carol, I appreciate the comment and the question. It would be totally irresponsible for me to recommend an individual stock for anyone without knowing more about their personal situation. Although individual stock investing is appropriate for some, I believe most investors are better off going for index funds. My next post on Sept. 9 will talk more about my favorite index funds. I’d enjoy your feedback tomorrow.
@50, I am so glad you brought up that point! It highlights the investing reality that your risk tolerance on paper could look quite a bit different after experience the ups and DOWNS of your own investments.For that reason, I suggest taking the results of a Risk quiz with a grain of salt.
@Tips, Thanks for reiterating the challenge of making investment decisions. As in life, there is no certainty (well, except death & taxes)
@Khaleef, You never disappoint. Valuation is crucial, regardless of one’s allocation if you purchase overvalued asset classes (or individual securities), your results will suffer.
Thank you all for the thoughtful and provocative comments.
Hi Barb,
When I did my infinite portfolio series, I read that a high stock portfolio allocation can actually be beneficial even when older (i.e. 75% stock/25% bonds), so long as you started investing when younger and you limit withdrawals to 3% – 4% per year.
Why? Over the long run, the higher stock allocation leads to higher total portfolio values, and the long time period smooths out variance without sacrificing the long-term returns. Whenever the stock markets go down a lot, that’s in fact a time to go all-in! I wouldn’t count on the markets for a 2 year investment, but I think it becomes a different ball-game when one is planning for the long-term.
Can be a sound strategy if the older investor has enough liquid investments that he/she does not need to cash out stock investments at an inopportune time. Many older investors were over-invested in stocks during the 2008 drop and were forced to sell in a declining market.
Thanks for the perspective.
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Conventional wisdom is not always wise. Investing must always be structured for each person.
I am of the belief that it is better to adjust your lifestyle to your risk tolerance. There is no justification to go for higher risk/return and stress daily about your portfolio. Living life is more important.
It is possible to balance the two.
Kim, Excellent point. I couldn’t agree more. Thank you for the insight.
[...] PART 1 of this series, I talked about my investing [...]