People, in general, overgrow their desire to undertake certain risky sports or activities, such as hang-gliding, sailing, car-racing or even taking backpacking trips to exotic lands. Youth brings with it the adrenaline drive to risk life, limb and property; whereas age succumbs to the comfort and safety of less-challenging and more family-oriented diversions.
Nevertheless, while majority of us improve our skills at evaluating risk as we mature, we somehow fail to assess financial risk as much as we should. In seems that in the stock market, we remain like tots unaware of the dangers that lurk in the forest.
Until the winds blow high and hard upon us, we feel unconcerned about the risks even to the point that we totally give up on investing.
Appreciating your risk tolerance is vital. Beginner investors often take so little risk and end up with un-invested and unproductive money lying around. Meaning to say, your money grows at a lower rate or is earning nothing whatsoever. The loss of time is a loss of opportunity which might never be recovered in the future.
This is exactly what happens to those who try to recover lost time in their later years by saving and trying to make up for the lost time. This results in the investor tending to take more risk than necessary, endangering their investment and their personal future.
Just like people who have beginner’s luck, an investor can be lulled into thinking that a few early successes prove one’s ability to make future consistent gains. Blind luck does not mean solid investment skills. You will realize this when your luck runs out. And then we put the blame on others except ourselves -- the markets, the banks, the government and everyone else.
How do you measure your risk tolerance? You may be surprised how easy it is. Ask yourself these four essential questions and see how financial experts do it:
1. When will you need the money?
If your time frame is, say 30 years in which you save and invest, you have high chances of weathering a few setbacks along the way. But if you are five years away from retiring, the assumption will drastically change.
2. How many years will you spend in productive work? How many years in retirement?
Many people reach retirement age unable to quit working because they have no savings. For those who plan to work during retirement, they make have higher risk levels compared to those who will not.
Likewise, consider how long you might end up living in retirement. Oftentimes, running out of money in your later years is inevitable.
3. How do you respond when markets rise?
Do you celebrate and go on a shopping binge? People forget that they have not even made money on their investments, not until they sell those assets many years from now. Also, there are investors who see a rising market as a go-signal to invest more heavily, not realizing they are actually buying at much higher prices.
4. How do you respond when markets fall?
Do you feel depressed? Or fearful? In the same token, why should you feel down when you have not lost any money until you sell at a lower price than that at which you bought the stocks? Moreover, investors do not take the opportunity to buy as stock prices decrease, not the applying the vital rule to “buy low and sell high”.
Properly assessing investment risk and determining your risk tolerance level is a crucial factor in any long-term retirement strategy. But if you learn the basic tricks, you can protect yourself from the common emotional trading pitfalls that retirement savers often experience.