Understanding Your True Risk Tolerance is Vital to Portfolio Performance

Understanding your risk tolerance is one of the most important elements of investing; knowing how your risk tolerance effects your investment decisions is vital to the health of your portfolio.

Risk tolerance is most prevalently understood as a measure of one’s financial ability to withstand losses. On the risk-reward continuum, the more risk one takes, the greater the reward should be expected, and vice versa. For example, an investor who can withstand a 25 percent loss in his portfolio value without it affecting his ability to meet his long-term goals may be able to invest more aggressively in order to achieve potentially higher returns than someone who couldn’t afford to lose more than 10 percent. The financial measure of risk tolerance is a function of several factors including time horizon, income, liquidity, and net worth. Generally, the more of each an investor has, the more risk he may be able to assume because of the greater capacity to recoup losses.

Less understood is the emotional component of risk tolerance, yet it can have far more influence over investment decisions than the financial ability component. Emotions are far more powerful than logic and can drive investors to make decisions without regard for their financial ability. The two emotions that can be the most devastating to investors are fear and greed, and both can be triggered through the behavior of a reactionary crowd. It’s what can lead investors to flee the stock market in mass after it has already fallen by 15 percent; and it’s what can draw investors into a raging market rally near its peak. In either case, investor risk tolerance is skewed by emotions which often results in investment decisions that bear no reflection of their long-term investment strategy.

Still, emotions are an important element in risk tolerance when they are understood. Fear breeds caution which is never a bad thing in investing. But realizing that emotions are reactionary mechanisms that tend to drive decisions based on short term events, may help investors keep them in check when viewed in the context of a long-term investment strategy. It would be hard not to lose some sleep when the stock market experiences a flash crash of 1000 points. You wouldn’t be human if you didn’t. However, realizing that the only people affected by such a crash are the ones who actually sell their stocks, might help to keep a short-term event – positive or negative – in perspective.

Generally, investors who tend to focus primarily on the markets might experience a roller coaster of emotions. As a consequence, their confidence is more tied to the performance of the market. Conversely, investors who stay focused on their long-term investment strategy need only to have confidence in the strategy. If it’s well-conceived with optimum diversification and well-managed through proper re-balancing and adjustments for an evolving risk tolerance, they can be more secure in their confidence.