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Determining risk tolerance

Determining risk tolerance

Before investing, it’s critical to determine your risk tolerance. But how do you go about doing that?

When I’ve worked with financial people in the past, they’ve usually had a little quiz that you take that tells you what they estimate your risk tolerance to be. Most of the quizzes I’ve taken have had questions designed to figure out how your money should be invested. (Which makes sense.) A few go into more detail.

It’s a lot easier for me to answer those questions than it is to figure out how I might really feel about some future situation. To me, THAT is the important part, because how I might feel affects how I might act.

Right now, a lot of people are getting to experience exactly how they would feel in a very down market, and to see how they would act in response. For example, maybe you’ve said in the past that you would sit tight or add to your holdings if stocks went down 30%. But how do you feel now that they have really done so? Are you doing what you thought you would? This is one way to figure out what your feelings about risk really are, so that you can at least plan accordingly from now on.

But of course feelings are not the only aspect to risk tolerance. When it comes to investing, factors like your age, when you want to retire, how much money you already have saved and invested, what you want your future to be like, how many people you are supporting, your job stability, and more come into play.

For myself, I’ve learned that I have an odd mixture of both very little and a whole lot of tolerance for risk. In many areas, I am extremely conservative. We’re paying off our mortgage, I believe in having a year’s worth of expenditures saved for emergencies, and I will take guaranteed cash in my hot little hands right now over the uncertain possibility of more cash later. But at the same time, I’m fine with investing extra money in emerging markets, with buying single stocks, with watching a stock drop 60% or more that I believe will come back up in 10 years or so, with starting new businesses, with deliberately speculating/betting a little, etc.

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The difference in how I feel has to do with how I view the money in question. Is it extra money or is it money that I definitely need to maintain the lifestyle I want? That’s a little bit silly and nonsensical, but no one ever said feelings were logical.

What about you? How has your tolerance for risk affected the choices you make?

View Comment (1)
  • I think that investing is an inherently risky activity. For an invested individual in 2008, this meant an across-the-board decline of any carefully constructed portfolio. Diversification mattered little. Geographically, Asia, Europe, North America and Australia all suffered. Across most sectors, stocks stayed depressed.

    In this kind of globally intertwined environment, without a good macro understanding of the market, no one business or sector can be proclaimed safe based purely on its own merits. So perhaps it would be good to re-assess one’s true risk tolerance in face of so much uncertainty.

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