Investors are not always honest with themselves about their risk tolerance. Most investors overestimate how much risk they are willing to accept. And, some even drastically underestimate their willingness to handle risks in the stock market.
After the internet bubble burst in 2000, the United States rebounded and enjoyed a prosperous bull market. Investors faced a bull market coupled with low unemployment and quickly rising housing prices. Most investors told themselves and their financial advisors that they were in the market for the long term. They understood that markets do not go up in a straight line and that there could be some down years. (To see the top 4 things to consider when choosing a financial advisor go here.)
Investors told themselves that they could withstand the market swings. Of course, saying that you can ride out market bumps and doing it in the face of a 30% or more declines in your 401k retirement plans is an entirely different story. Long-term investors and people who thought they had a high-risk tolerance bailed for the exits by the thousands. Billions of dollars moved out of equities and into cash and cash equivalents on the sidelines of the market. Were investors really honest with themselves about their risk tolerances before the market crisis of 2008? The exodus implies that we were not.
Are You Honest With Yourself About Risk?
Most investors are not honest with themselves about their risk tolerance. The market crisis of 2008 clearly showed us that. In fact, investors are overconfident. We like to think that we have the stomach for risk, but the reality is far different from what we can handle.
There are many different factors that go into determining your risk tolerance. Risk tolerance will vary from one person to another based on the investor’s age, investing experience level, your net worth, time horizon, investing goals, ability to mentally handle losses, and the types of investments that you are considering. Knowing and understanding how you respond to risk as an investor can help you to find a balanced and diversified plan for your investing that will help you reach your financial goals.
Could you stomach another 30% short-term correction in the market? Could you handle another short-term dip like that in return for a very long-term bull market to follow?
The Great Recession, market crisis, and housing turmoil from 2008 continue to linger in the minds of investors. To be blunt, we are gun shy now. Investors continue to have a bad taste in our mouths about investing.
Because of these events, many investors have swung the opposite direction. We do not want to take on too much risk. Now investors are sitting on the sidelines with little to no risk and not investing in the markets. They are missing the market’s recent rise.
How To Find Out Your Risk Tolerance
If you are working with a financial planner or brokerage firm, they most likely have a worksheet or questionnaire that can help you determine where you fall in the risk tolerance categories. There are also several questionnaires that you can complete online to get a sense as well.
It all comes down to knowing yourself and understanding the risks that you are willing to take. How much risk can you tolerate? Are you a gambler with your family’s finances and investing goals? Are you an ostrich hiding your head in the sand with all your money in cash and money market funds? Or, do you fall somewhere in the middle?
A great online risk tolerance questionnaire is available through the Rutgers University. It was developed using academic research conducted over the last 15 years. The questionnaire is a way to get a quick snapshot of how you think about risk by answering several probing money questions.
Finding the right risk tolerance is a difficult balancing act. It requires investors to know themselves, understand their investing time horizons, and understand the goals as to why they are investing in the first place.
It is okay to be a little risk adverse. But, investors must ensure that they find the right balance between risk versus reward. While it may not be acceptable and conducive to your financial goals to have 100% of your nest egg invested all in stocks, it is also not wise to avoid all risk and sit on the investing sidelines either. Understanding your risk tolerance is to know yourself and what you can handle. Like G.I. Joe always said, “Knowing is half the battle.”
About Hank Coleman
Hank Coleman is a finance writer, financial planner, and self-proclaimed all around investing junkie. He has a Masters Degree in Finance and a Graduate Certificate in Financial Planning. Be sure to follow him on Twitter at @MoneyQandA and on his blog, Money Q&A.
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