You are now an expert on risk tolerance!
Congratulations. But who cares? As the familiar saying goes, “You can’t pay your rent with risk tolerance.”
Well, now, maybe you can.
Let’s look at an example of two people:
Clueless Karen and Insightful Irene.
Clueless Karen has never heard of risk tolerance and is definitely not money smart. She just started investing because she thought it was the right thing to do.
Insightful Irene, on the other hand, has read a brilliant financial self-help book and understands volatility and her own risk tolerance. What happens as each of them invests?
Imagine they both wake up on the same day, and they notice the market is down 5%. Clueless Karen wasn’t prepared for this. Her investments were quite risky and her portfolio is down 10%. She can’t handle the loss. She immediately decides to sell everything because she just can’t bear to see any more losses.
Insightful Irene looks at her portfolio. She sees that it is down 2%. She’s not happy, but 2% is not a disaster. She goes about her day, not thinking about it again.
What’s happened here?
Clueless Karen acted emotionally and irrationally. She wasn’t thinking about the long-term value of her investments or her overall financial plan. She made her entire decision based on how she was feeling about the losses. And guess what? This is how humans make decisions. We do not have a logical Dr. Spock-like response. We feel and we react, not to facts, but to emotions. The problem with this approach is that our emotions can cause us to act in ways that may not be in our long-term best interest.
Insightful Irene is just as scared of risk and volatility as Clueless Karen. She hates losses and is just as emotional and prone to making bad decisions. But—and this is why she’s insightful—she understands this about herself. She knows she would react just as emotionally as Karen if her portfolio was down 10%. This is why she invested her money differently. More safely. With less volatile investments. This way, she loses less and won’t have the same gut wrenching feeling and won’t make quick emotional trades.
The power isn’t so much knowing your risk tolerance, but knowing your risk tolerance and allowing that to guide how you invest.
You want your portfolio invested in a way that is closely aligned with your ability to withstand volatility and short-term losses.
If Clueless Karen had known her risk tolerance, she never would have been so aggressively invested, and she wouldn’t have lost 10% that day, and she wouldn’t have sold everything, and she wouldn’t have kicked herself when the market went up 25% the next year.
Be like Insightful Irene. Know your risk tolerance. It will make you a better long-term investor.
But that’s just part of the story. A lot of people are quite nervous about investing and worried about seeing their investments go up and down. Let’s dig into that a bit more next.
The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.