Understanding Your True Risk Tolerance
Louis Butera | February 02, 2022
The recent stock market volatility, the bear market, the ever-growing inflation rate, and ongoing supply issues have taken a severe toll on the American psyche. For some, it has forever altered how they perceive and manage risk.
Understanding your risk tolerance is considered one of the most important elements of investing.
Many people see risk tolerance as a measure of their financial ability to withstand losses. In theory, the more risk you take, the more potential for reward, and more potential for loss. For example, a person who can withstand a heavy loss in their portfolio without it compromising their ability to meet their goals may choose to invest more aggressively than someone who has a lower tolerance for loss. There are several factors to consider when determining your risk tolerance including income, net worth, liquidity, and time horizon. A financial professional can help you assess your situation and determine a level of risk that’s suitable for you and your goals.
Emotional Risk Tolerance
The emotional component of risk tolerance can have far more influence over your decisions than your financial capacity. Emotions are powerful enough to override logic and can drive people to decisions that may not be aligned with their overall financial plan. The main emotions to be mindful of are fear and exuberance; both can be triggered by the irrational behavior of reactionary crowds and media. This response is powerful enough to lead people to flee the stock market en masse after it’s already fallen and draw people into a raging market near its peak. In both scenarios, individual risk tolerance is being skewed by emotions, which leads to divisions that do not reflect their long-term strategy.
Emotions are an important element of risk tolerance and shouldn’t be overlooked. Understanding that emotions are reactionary mechanisms that tend to flare up over short-term events may keep you in check when looking at the context of your long-term strategy. It would be hard to not lose sleep if the market suddenly crashed. It’s a natural human response. But, realizing that, you don’t have to act on those sudden emotional responses, especially if it works against you in the long run.
Focus on the Long-Term
It’s generally believed that people who focus primarily on the markets will experience a roller coaster of emotions. Because of this, their confidence may be tied to their market performance. On the other hand, investors that focus on their long-term strategy need only to have confidence in their strategy. If the plan is well-balanced, diversified, and managed through proper rebalancing for evolving risk tolerance, short-term market events may have less impact.