Can You Handle The Risk? Understanding Your Risk Tolerance

The risk of losing money is understandably a big fear for investors. Investing is a great way to grow your wealth, but there's a tradeoff. The opportunity for your investments to rise is accompanied with the risk they might fall (risk and reward).

Everyone's ability to handle risk is different, a risk-appropriate portfolio is key to successful investing. Investors taking on too much risk are likely to make poor decisions under pressure (like JR Smith in the NBA Finals). Investors who are too conservative are limiting their growth potential.

Most portfolios are built with a mix of stocks and bonds. Stocks are typically riskier and provide greater returns, bonds are typically more stable and provide lower returns. A paper by PWL Capital found that stocks had an expected return of 7% and a standard deviation of 11.4%, while bonds had an expected return of 3.3% and a standard deviation of 3.9%.

Standard deviation is the degree that returns deviate from the annual average. The higher the standard deviation, the more volatile your returns. To expect higher returns in the long run, you must be willing to subject yourself to higher volatility in the short run.

There are two factors to understanding your risk tolerance - your ability to take risks and your willingness to take risks. Ability is a function of your time horizon and willingness is a function of your personality.

Time horizon is a fancy way of saying when you'll need the money, like pugilism is a fancy way of saying boxing (and boxing is a fancy way of saying fist fight). If you have a long time horizon (10+ years), you're able to endure more market volatility. You can ride out recessions and enjoy the expected long term growth of the stock market.

If your time horizon is short (say less than 5 years), you can't afford the risk of a market downturn. The sooner you need the money, the more stable your investments should be. You wouldn't want to be near retirement, only to have your investments cut in half (see 2008).

Willingness is about your personality. When markets are down, will you lose sleep? Will you make impulse decisions? If you can't stomach the rollercoaster ride of returns, you should allocate more to stable assets such as bonds.

Willingness is often overlooked when determining risk tolerance. Remember, you have to be both able AND willing to take risks. A young professional with decades to retirement is able to take on more risk, but if their personality lends them to be frantic in turbulent times, then a portfolio of mostly stocks won't be right for them.

Understanding your risk tolerance is the foundation to your financial plan. Before you jump into investing, take the time to understand yourself and your ability to handle risk.

Comments

The Art of Giving Feedback

Constructive feedback is an awkward affair. You don't want hurt feelings, but recognize the importance of honesty. You've tried the classic "hoping things will get better on its own" and unfortunately it hasn't played out. When giving feedback, here are a few things that I try to keep it mind. Start with empathy. Step into their shoes and understand their story. If you don't know, ask. Be genuinely curious. Feedback is a dynamic affair. Shared communication with a shared goal towards progress. Take the emotion out of it. Focus on the situation, not the person. Focusing on the person adds unnecessary weight to an already emotionally-bloated event. Be specific. Give clear examples. Vague feedback equals dismissed feedback. Doing above won't de-awkward things fully, but it will dampen it and increase the chance of better outcomes.

Bias For Clarity

Bias for action. Gets things done. Go-getter. Traits companies big and small look for. And for good reason, you're being hired to do things! However, action is a secondary step that often overshadows the primary step, direction. Clear direction is the foundation that enables our actions to takeoff. Without it, we're stuck in the mud. Striving for clarity is an underrated skill. Having the courage to ask ( seemingly ) obvious questions, and to check in, making sure we're all on the same page. "O bvious " questions are a low risk, high reward way to add value. At worst, you'll add confidence to our actions. At best, you discover a misalignment that saves us from a dead-end. The more people, the more clear we need to be. The bigger the initiative, the bigger the risk of reaching the finish line, only to realize expectations were off. Success is always uncertain. But we can be certain about what we want and what everyone's job is. Things that can be clea...

Negative Feedback, Positive Lessons

In the battle against plastic bags, a five-cent tax was shown to be much more successful at deterring usage than a five-cent credit for bringing your own bags. Carrots satisfy but sticks sting, and they sting hard. So we default to the less painful choice of avoiding loss. Loss aversion impacts the way we process information. A 2019 study invited participants to learn through a series of multiple choice questions. Each question only had two options to choose from. Whether guessing correctly or not, they would still learn the right answer. Despite the identical learning opportunity, participants were much more successful at recalling the answers they guessed correctly than those they got wrong. "You're right!" feels good. We savour the moment, analyzing every detail. "You're wrong!" stings. We want to quickly forget, dismiss, and move on. When we succumb to loss aversion, we miss opportunities to learn. Failure is part of the process. We'll experie...

Herman Ye

Search