Managing Emotions With Risk Tolerance
Understanding your risk tolerance is considered one of the most important elements of investing and is something we discuss with clients on an ongoing basis.
Many people see risk tolerance as a measure of their financial ability to withstand losses. In theory, the greater the risk a person takes, the greater the reward he or she may receive. On the other hand, taking less risk may mean less reward. This principle is called the risk/reward trade-off. There are several factors to consider when determining your risk tolerance including income, net worth, liquidity, and time horizon.
The emotional component of risk tolerance can have far more influence over your decisions than your financial capacity and can drive people to decisions that may not be aligned with their overall financial plans. The main emotions to be mindful of are fear and exuberance; both can be triggered by the irrational behavior of reactionary crowds and media. This response is powerful enough to lead people to flee the stock market en masse after it’s already fallen and draw people into a raging market near its peak. In both scenarios, risk tolerance is being skewed by emotions.
Being aware that emotions are reactionary mechanisms that tend to flare up over short-term events may keep you in check when looking at the context of your long-term strategy. It would be hard to not lose sleep if the market suddenly crashed. It’s a natural human response. But you don’t have to act on those sudden emotional responses, especially if it works against you in the long run. Investors that focus on their long-term strategy need only have confidence in their strategy, not market performance.