Reality is pretty subjective. That might sound strange, as most of us — especially those of us who pride ourselves on objective, rational, evidence-based thought — tend to believe reality is what it is. It’s not up to us to argue with facts.
But consider this: as we’re in the depths of winter, the thought of the first truly hot, sunny day of spring is probably quite appealing. We can’t wait to be done with dark, dreary, freezing-cold days and the idea of feeling hot air and intense sun sounds ideal.
Our perception of a hot day right now, in the middle of winter, is very different than our perception of a hot day when the calendar shows it’s late August. At that point, most of us are sick and tired of the heat and desperately wishing for that first cool, crisp autumn day to arrive.
Depending on the circumstances, what’s real doesn’t always feel constant. Our perceptions often determine what’s “real” to us in any given moment — and those perceptions can change over time or depending on context.
How Circumstances Impact Our Perceptions When We Invest
Having very different reactions to similar sets of conditions happens often in many areas of life — including our investments and our perception of the risks we take with them.
The ability to gain an understanding of the risk tolerance of investors is one of the most critical components of successful long-term investing, which is why risk tolerance questionnaires are so popular. These questionnaires seek to provide investors with an understanding of what kind of market conditions, events, or extremes would push them to deviate from a set plan.
Given that the biggest risk to most investors with long time horizons is pulling money out of the market at the exact wrong time because they can’t tolerate the dramatic highs and lows in their portfolio, this knowledge is crucial to have.
But the problem is that, just as our feelings about a really hot day will change depending on whether we’re in the middle of winter or a summertime heatwave, our perceptions of risk are not fixed. They change based on the circumstances as well.
Your Risk Tolerance Will Change with Your Perceptions Over Time
To understand this, let’s look back to March 2009. The S&P 500 had declined by 50% over the previous year and a half and officially hit its bottom during the Great Recession.
Investors were scared and despondent. Many fled the market to cash. Those who remained wondered how much farther stocks would fall.
Now, imagine completing a survey of your risk tolerance in these market conditions. How do you think you would score, based on your perception of risk within this context?
Let’s return to the present. It’s 2020 and the eleventh year of a record-long expansion for stocks. Since March 2009, the S&P 500 has averaged an annualized return of 17%, nearly double its long-term average. In 2019, the index was up an astounding 31% and didn’t experience a single 10% correction (that we normally expect to see each year).1
Do you think if you took a risk tolerance score right now, your result might look a little different than it did if you took the same survey back in March 2009?
This is the problem in relying too heavily on risk tolerance questionnaires to determine how you should invest: how you feel about risk is not a fixed trait. It can — and likely will — change over time.
The Question You Must Answer: What’s My Real Tolerance for Risk?
In evaluating your tolerance for investment risk, a good place to start is the old adage, “you’re never as good as your best day or as bad as your worst day.”
Most investors are not as risk-averse as they think they are on days like March 2009 — but they’re also not as tolerant of risk as they might believe as they experience a great market run like the one that’s been going for the last 11 years.
So how do you understand what your real tolerance for risk is? How do you know where you truly stand when you’re not being influenced by the immediate or recent past?
Start with these considerations:
Self-Awareness: The ability to solve most problems in life starts with identifying potential pitfalls that we could fall into unless we acknowledge them. Without that acknowledgement, we have less awareness — and without the awareness of the problem or trend, we have no hope of avoiding it. Understanding we might be tempted to reduce risk in down markets and ratchet up risk in up markets helps us avoid blindly acting on these ill-contrived instincts.
Evaluate Risk Tolerance Periodically (Not Just Once): We know our tolerance for risk can change in different market conditions. Therefore, it’s a good idea to periodically evaluate and re-evaluate your tolerance to look for trends or changes. We already know that things like age can change our perception of risk; other changes to your life or your finances might influence how you feel over time, too.
Think in $, Not %: One drawback of many risk tolerance questionnaires is that they ask investors if they would remain invested if they lost 10%, 20%, or 30% of their portfolios. But that doesn’t feel real to most people because we use dollars to buy groceries and pay bills, not percentages.
Make sure to do the same when assessing risk, and reframe the question. If you have $500,000 invested, would you remain invested if you lost $50,000, $100,000, $150,000? Talking in real dollars can elicit the same type of emotion you may feel when markets are falling, giving you a better read of your true tolerance for risk.
Have an Action Plan or a Non-Action Plan: Just as sports teams create game plans to improve their chances of winning, investors can (and should!) create a financial plan to navigate the ups and downs of the market and their lives over time.
Consider putting the actions you will take (and won’t take) during the next market decline in writing. For instance, maybe you will commit to rebalancing your portfolio and looking for attractive buying opportunities — but you won’t engage in panic-selling or going to cash. Putting a plan in place increases your chances of a positive result when the game is on the line.
Much like our perception of how much we’d enjoy a very hot day will change depending on if we consider the question in the dead of winter or the dog days of summer, how we feel about taking risks can fluctuate, too. Your risk tolerance is not static, which means simply taking one questionnaire, one time, is not sufficient for truly understanding your actual comfort with how your portfolio is invested.
By applying the considerations above, investors can get a better feel for owning the right balance of stocks and bonds in their portfolio that will allow them to stay the course during the next market storm – which is the most important goal for long-term investors in achieving their financial goals.
Now, back to daydreaming about that first hot, sunny day of spring.
Source: 1 Morningstar
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