The Dangers of Not Understanding Your Risk Tolerance

When it comes to finance, risk tolerance refers to how much uncertainty an investor is willing and able to take, including the possibility of losses.

For many years, investors have determined how much to invest in stocks, bonds, and similar assets, referred to as one's asset allocation (e.g., 70% in stocks and 30% in bonds), based on their estimated risk tolerance. Investors with higher risk tolerance are generally able to have a greater portion of their portfolios in asset classes with higher expected returns, such as stocks.

To this end, questionnaires that attempt to (quite crudely) measure investors' risk tolerance using mostly hypothetical scenarios are often used by financial advisors, brokers, and others. Perhaps the biggest concern is that if investors overestimate their risk tolerance and invest too much into volatile assets , they will panic when losses inevitably occur, sell the volatile assets, and bail on their financial plan, resulting in worse long-term results than had they stuck with their plan and given their investments time to recover.

However, all of this is built on a big assumption that is seldom discussed: investors can accurately forecast what their risk tolerance will be in the future when their finances and future are on the line and when they are confronted with very difficult scenarios.

Do you see the problem with this assumption?

It's one thing to say that you will stick to your plan when stocks drop in value by 30%, for instance. But it's another thing entirely to actually do that when stocks have dropped in value by 30%, all the news is indicating that the economy is tanking, there is major geopolitical upheaval, you've lost your job, medical bills are piling up, and it feels like your life has turned into a Hank Williams' song.

It's normal for asset classes like stocks to not fall in a 'vacuum'. Rather, such falls are usually accompanied by negative events that can be unnerving or downright frightening to even very experienced investors.

During such downturns, major companies may be laying off thousands (or millions) of workers. There are often many who question whether the economy will go into a recession or even a depression, which often conjures up images of dejected men standing in breadlines.

The Depression Breadline sculpture in Washington D.C.

And, of course, there is no guarantee that the stocks which have just taken a big hit won't continue to drop even more and/or that they won't recover for a long time, a decade or longer.

Many of even the most vocal proponents of a buy-and-hold strategy, where assets are bought and held for the long-term without regard for future changes in the assets' price, were questioning their approach during the stock downturn of 2008-2009, when stocks dropped in value by about 50%. And this was for good reason: there is no guarantee that stocks will recover over any given period of time.

Are investors thinking about all of this when they respond to 10 short questions asking about their risk tolerance?

Given all this, it's vital for investors to not just focus on how they believe they would react to their investments dropping in value significantly. They should also take into account that big declines in assets like stocks are likely to come along with other negative events that may be even more troubling than the decline in stock values. Consequently, investors should be very careful to not overestimate their risk tolerance in very volatile environments that are not only defined by stock drops.

Investors need to carefully consider what their risk tolerance might be when it seems like the world is crashing in on itself. Because, at some point, a long-term investor is likely to believe that is precisely what is happening.