When we go through drops in the market, there are always observers and investors wondering whether it’s time to change one’s portfolio. It’s understandable, considering the emotional response to losing money, and the clear news story it presents for journalists to write about it. What happens simultaneously, of course, is market analysts, CEOs and definitely financial planners come out with the drum beat to stay put and focus on the long term. Perhaps they are right. Over hundreds of years, the markets have ended up going higher and making people money. If you focus on your risk tolerance, you should be properly allocated.
Here’s the problem, however, with telling everyone to hold tight and ride it out regardless of their personal circumstances, current allocation, goals, time horizon and so on: people don’t know their risk tolerance.
Comparing Risk Tolerance Scores at Cocktail Parties
Let’s walk through an example. Let’s say you are standing in front of a giant roller coaster. It’s a massive, winding, scream-causing contraption that supposedly is enjoyable to some people, and you are deciding whether to get on. You watch scary movies every once in a while, don’t faint at the site of blood, why shouldn’t you have a tolerance for fear big enough to get on? You can handle it.
To take it once step further, someone walks over and offers you a questionnaire about fear. They ask, “On a scale of one to 10, if you were in a shaking car that goes up and down how nervous would you be?” “If you were suddenly falling out of the sky, what would your fear level be?” and so on.
You are brave. You want to impress your spouse, kids or grandkids and be there for them (just like you want your money to be there for them), so you answer a bunch of these 1-10 scale questions and get a score of 47. Your score means you are above-average at taking risk and this roller coaster is a perfect size for you. Once you get on and strapped in, the roller coaster starts going up (kind of the markets sometimes do at first). You say to yourself, “Hey, this is great. What was I afraid of? What a great view. Think of all the other exciting things I could try.” Then the ride turns the corner. When you and your lunch start heading downhill, it’s a whole new ballgame and that 47 score may not mean a whole lot to you anymore. This is where you find out just how potent your fears are — when they are actually happening to you. Unfortunately, one of life’s great mysteries is that the only way to really gauge your fear is to experience it.
So What Does This Mean for Your Money?
Here’s what this scenario is meant to convey: Just because your financial planner has been doing this a long time and has crunched all kinds of numbers, you are the only one in control of your tolerance for fear and loss. Even it is supposedly temporary. So when you see your account going down and read the headlines full of bad news, you have to assess yourself and decide if this is really what you want your money to be doing.
Maybe you’re OK with a little bit of up and down, or maybe not. If your current investment plan was set up for you and it was thorough and included your input, it probably has some merit to it, but a more conservative version may also be a better fit for you personally.
To get an idea of whether you have the right plan, you can look at how much you have in stocks versus bonds or other asset classes. Look at what has gone down over the last few weeks. These positions are correlated together, meaning they will tend to move in similar ways. The downside here is if you move out of these positions because of recent movements, and the markets come around while you stay conservative, you could end up with less money down the road. The best part is, though, unlike when you’re heading over the top of the roller coaster, you can still do something about it.
This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.
More Money-Saving Reads: