Have you ever found yourself in the middle of a project only to realize you left out the most important parts that should have come sooner? To use an example, imagine that you are going to bake a cake for one of your best friend’s upcoming birthday. You go to the local grocery store, pick out all the ingredients to make a carrot cake. And, while you are pulling out of the grocery store parking lot, you call your friend to share this excitement only to have them tell you they are allergic to flour. Ugh! You think to yourself: How come I didn’t ask them first. In this post we are going to look at risk tolerance, one if not the most important concepts that almost no one talks about. This oversight leads to unnecessary financial pain and stress. If you want to learn how to avoid this and you’re tired of getting burned in one investment after another, read on.
When it comes to investing in the stock market or the housing market, finding out what you’re “allergic” to is extremely important to your investment success. A term you have probably heard before and one we that we will focus on in this post is risk tolerance. When it comes to becoming a successful investor, defining and respecting your risk tolerance is one of the most important and least understood concepts. And just like you know what foods you’re allergic to, you need to learn what investments or investment styles will keep you up at night.
Like Socrates’ guiding rule “Know Thyself”
Our experiences shape us and create the person we are today. However, most mainstream invest media try to plug people into a box or subset to by calling us things like conservative, moderate or aggressive when it comes to describing our risk tolerance. And, while this is helpful, it’s limiting.
In my more than 20 years in the investment industry, I’ve learned that investors skip this most critical part of self-examination. Instead of understanding their internal makeup for risk and defining specific boundaries (parameters of what they will invest in), most of us look directly to an investment’s 12-month trailing return as if it were a prescription for the upcoming 12- months. The result of this can be seen in the aftermath of the tech stock bubble and most recently, the housing market.
If we are going to reach financial independence, we need to understand how money works and not blindly assume anything. Do you want to know who’s fault the housing market was? In my opinion, it wasn’t just Goldman Sachs or your mortgage broker. Each and everyone of us that purchased a house that we knew was more than we could afford, participated in the housing crisis. If you bought a home solely on the capital gains potential as in because the person’s home across the street went up 30% in 2005, you are now realizing the dangers of not respecting your risk tolerance. Keeping up with the Jonses will never do anything more than keep you from what is most important to you. It will keep you from your definition of financial independence. After all, isn’t financial independence what we all want anyway? And by financial independence, I am not talking about making a gazillion dollars. I am referring to what makes you feel feel secure and stable at night. That’s what you need to focus on.
Periodically, I will have friends come to me about the next great deal that is supposed to make them a fortune and if I would only listen, I too could make the same fortune. 100% of those deals end up being flops and sore subjects to avoid in future conversation. The real reason isn’t because these are bad people. They just don’t realize that anything that is a “given” is usually just someone selling them their baggage. (See video below) How do you think P.T. Barnum came up with the slogan “There’s a sucker born every minute” ? I want you to be smarter than that!
Understand that “Wall Street’s” pretty boys base most of their success on the sucker’s bet. If you ever had any question of this, just watch this clip from You Tube. The people from Goldman Sach’s believe it’s cool, cute to lie deceive and play games. Because you know this, what does that make you if you continue to give these guys your money? Yes, a sucker. Please note there is some profanity in this clip.
The point of this post is not to draw attention to Goldman Sachs or chastise Wall Street. It is impress upon you the importance of understanding your risk tolerance. Not mine, not Warren Buffet’s, but yours. Because if you don’t take the time to do this, you will end up frustrated and possibly even broke. If you think I am kidding, look at the damage the housing market has caused some families. Truth is most of that could have been avoided with some basic education.
We will get into portfolio building strategies in a different post. I will share with you how I design my investment allocation to match my risk profile. I can tell you it’s anything but mainstream. But it allows me to sleep really well at night. That’s the point. Believe me having a million dollars or “making a killing” wont do a thing for you if you don’t realize peace of mind with it.
The First Step In Defining Your Risk Tolerance
The first step in understanding your risk tolerance is to answer a few questions:
1- Do you get nervous every time the stock market drops 100 points?
2- Do you feel like you’re missing out every time the stock market is going higher, possibly with out you?
3- Do you feel that investing is just over your head; so, you just do what everyone else does and cross your fingers?
4- How would you feel if your investment lost 10%, 20%, 30% or even 50%? This question is critical in determining what you ultimately decide to invest in.
4a – Do you realize that bonds can lose as much as stocks? Even more, do you realize many bond mutual funds recently lost more than 15%?
5-Do you take time to truly evaluate the make up of your investments?
The answers to these questions will help determine the investments you select for your portfolio and the ones to avoid. It will also build the core concepts that define your risk tolerance. These concepts can be anything from consistent, low volatility, steady, to high volatility with the chance for high return and extreme speculation. It is important that you answer the questions above before we start to look at individual investments available in the market place.
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