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IT’S BEEN AN unpleasant seven weeks for the stock market. Is it over? I have no clue. Still, last week’s rally offered investors at least a temporary respite. My suggestion: Use this moment to think about the market’s recent rollercoaster ride—and how you’ve handled it emotionally.
Financial experts distinguish between risk capacity and risk tolerance. It’s a useful distinction. Risk capacity is our objective ability to take risk based on our personal situation, notably the reliability of our paycheck and our investment time horizon. The most important rule: If we have savings that we’ll need to spend over the next five years, that money should be in conservative investments, not stocks or riskier bonds.
Meanwhile, our risk tolerance is our emotional ability to weather market turbulence—and it’s a reason we might keep less in stocks than our risk capacity allows. But how much risk can we tolerate? It’s an issue that has long confounded experts.
That brings me to one of my pet peeves: risk tolerance questionnaires. Years ago, I remember questionnaires that confused physical bravery with investment courage, which was absurd. Warren Buffett is renowned for making bold investment bets when things look darkest—and I don’t believe he has any inclination to jump out of airplanes.
Even today, questionnaires regularly conflate high risk tolerance with a willingness to gamble, which I also find absurd. Many who buy lottery tickets, go to Vegas or take an occasional flier on a stock are otherwise very conservative with their money. I don’t view betting on one or two stocks as an indication of high risk tolerance. Rather, I view it as a sign of foolishness—and, if that’s all I owned, I too might cut and run during a bear market, because I’d worry the stocks may sink and never recover.
But even if risk tolerance questionnaires could accurately assess our risk tolerance today, we might feel quite different tomorrow. Research has found that we’re more willing to take risk if we’re desperately trying to avoid realizing a loss, or we’re in a good mood, or we’ve lately enjoyed some financial success and we’re feeling flush.
Indeed, probably the biggest problem with our risk tolerance is that it fluctuates along with share prices. Experts in behavioral finance have identified a host of reasons. We grow overconfident during rising markets, attributing our fattened portfolios to our own brilliance. We also feel like we’re ahead of the game financially, often leading us to take yet more risk.
But when stock prices turn lower, our overconfidence ebbs away, our aversion to losses kicks in, and we take the market’s decline and extrapolate it into the future. Soon enough, we assume share prices have only one direction to go—down. Many folks freeze, neither buying nor selling, because they worry they’ll make the situation worse. But for some folks, the fear of further losses is overwhelming, and they panic and sell.
Knowing we’re susceptible to these mental mistakes can make us better investors. It certainly helps me. Like everybody else, I’ve suffered emotional whiplash through this turbulent period. On days when the stock market plunges, I feel a tightening in my chest and I instinctively assume further declines lie ahead. But I’ve learned to pause, shove aside such fears and shovel more money into stocks. It has, however, taken decades of investing to develop that mindset.
What if you’re newer to investing? Even if you have 30 or 40 years to invest, I’d err on the conservative side initially. The best way to assess our risk tolerance isn’t with a questionnaire, but by seeing how we react when the stock market declines. That’s how we learn what our true risk tolerance is. In other words, the best guide to our future behavior is our past behavior.
That said, as we get more market cycles under our belt, we may discover we become more risk tolerant. We’ve been through bear markets and realize they’re temporary. To be sure, some individual stocks and even entire industries may fall by the wayside. But the global financial markets eventually march higher—and that’s what we own if, like so many HumbleDollar readers, we’re devotees of total market index funds.
Indeed, investing through total market funds is a strategy that deserves our utmost conviction. That conviction—coupled with the self-knowledge born of experience—can bolster our risk tolerance.
This is good news, though the news is also a tad bittersweet. How so? As we grow older, our risk tolerance may rise. But our objective capacity to take risk typically declines, as we quit the workforce and start living off our savings. The upshot: We’ve finally grown comfortable with the stock market—only to discover that we need to take less risk.
Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Facts of Life, Money and Me and 27 Things to Do Now.
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