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Psychology of Investing – Part 2: Understanding your True Tolerance for Risk

| July 01, 2014

If you read part 1 (Academics vs. Emotion) in our 3 part series on psychology and investing…..well, I’m kind of shocked you are back for part 2. Kidding aside, I focused on the importance of considering risk tolerance – or tolerance for short term volatility – in constructing investment portfolios. In this piece, I want to expand on some ways that can hopefully assist in determining just what your true tolerance for risk really is.

I think all of us remember (and may still be feeling) the pain and angst caused by the “great recession” of 2008-2009. I know I did – in close to 20 years of doing this, I have never felt so much fear and helplessness in guiding clients. Well, I am here to tell you that 2008-09 did offer one HUGE benefit to investors and advisors alike. It gave us a recent and very real benchmark of what happens to different types of investments when the poo REALLY hits the fan. Here is how you can use it to your advantage when constructing or analyzing your investment portfolio:

  1. Start again by determining your specific financial goals and objectives – in other words, determine WHAT needs to be accomplished – including timeframe for each. If this sounds redundant, that’s because it is always the most important step in the process.
  2. Match your objectives and timeframes with an appropriate general allocation (conservative, moderate, aggressive, etc.) from a purely academic standpoint. In other words, forget about risk for this step and focus on historical returns, cash flow, and asset classes.
  3. Do some research and see how that general allocation performed in 2008.

Now ask yourself (and you have to be brutally honest), “If the next 12 months replicated exactly the performance in 2008, would I be able to not only hold onto my investments without selling, but also be willing to rebalance into the components that were hit the hardest?” If the answer to the above is “no”, then you have a LOT more contemplating to do before making any final investment decisions. There is a lot more that goes into it – including making sure you understand what happened if you did in fact hold onto the investments and better yet rebalance appropriately – a good advisor will be able to help if you need some guidance along these lines.

People have asked me why I am so “pessimistic”, or why I always want to focus on the “worst case scenario”. Simple answer – I promise you that you will not lose any sleep while your investments are rising in value. You might start feeling a little greedy (the other detrimental emotion as it pertains to investing), but that’s another blog. It is a whole lot more difficult to stay the course in a rough market – so preparing for the worst case is prudent in my opinion.

As always, please remember that the opinions expressed in this writing are my own and do not necessarily reflect the opinions of LPL Financial…..seems to me that my family and friends would often like me to use the same disclaimer with them. I have also been asked to disclose that past performance does not guarantee future results.  That is one disclaimer I will never argue (see our previous blog, "Sabermetrics and the Stock Market)!

And most important, thank you to all of our clients for your continued trust and confidence in Round Hill Wealth Management.

Thanks for listening,