What’s Your Real Risk Tolerance?

With panic sweeping the stock market, it’s time to check your risk tolerance score. (You did take a risk tolerance quiz like this before investing your money, right?) The whole purpose of determining your risk tolerance is to use it as a guideline to create a mix of investments that you can “tolerate”…in other words, that you won’t bail out of during times like these. After all, if you do bail out and fail to get back in the market in time (and if you figure out a way to time the bottom, please let me know), you’ll miss the eventual recovery and turn a temporary loss into a permanent one.

There’s only one problem with this. Too often, risk tolerance quizzes simply document how we feel when we take them. If you took that risk tolerance quiz over the last few years, you might have taken it while the stock market was booming.  With 2008 a distant memory, it was easy to say that you’re comfortable with risk.

Now that you’re confronted with the prospect of a real decline, you may not be so sure. In other words, risk tolerance quizzes may only be reinforcing the problem they were intended to solve: people being too aggressive when times are good and too conservative when times are bad. This causes them to buy stocks while they’re relatively high and then sell them while they’re relatively low.

So what’s a better alternative? What people say they’ll do and what they actually do aren’t always the same so look at what you actually did during the last financial crisis in 2008. If you bought more stocks (and if you re-balanced, you did), consider yourself very aggressive and keep 80-100% in stocks. If you stayed the course and made no changes, consider yourself moderately aggressive and keep 60-80% in stocks. If you reduced your stock allocation, consider yourself moderately conservative and keep 40-60% in stocks. If you bailed out of stocks altogether, consider yourself very conservative and keep 20-40% in stocks. (Having less than 20% in stocks can actually make your portfolio MORE risky in the long term.)

If you weren’t investing in 2008, see how you react to the next market decline, which we may be in now. Your risk tolerance can also change over time. If you react differently to the next market decline, you may want to adjust as necessary. This is also a good way to make sure your portfolio really does match your risk tolerance even if it doesn’t change.

Of course, all of that assumes you have a long time frame (at least 5 years) before you need the money. Otherwise, you should keep it in cash regardless of your risk tolerance. After all, your risk tolerance doesn’t matter if you’re forced to sell in a down market because you need the money. But if you do have a long time horizon, think about how you actually reacted to the last market decline to determine your real risk tolerance before you invest.

 

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