Risk Tolerance and Smart Investing

Posted by Guest Author

This is a guest post by Carson Brackney, writer for Personal Finance Analyst. Personal Finance Analyst is an online community of bloggers dedicated to taking the mystery out of money and helping you to live a happier, more successful life with the money you have.

Risk Tolerance Calculators

New Jersey’s Cooperative Extension Services (operated out of Rutgers University) offer a great online quiz that will calculate your level of investment risk tolerance. If you don’t like that one, you can take a look at Yahoo’s free calculator. Still not happy? Merrill Lynch has their own. And there are others. Many others.

And all of the calculators attempt to do the same thing, they want to tell you how much risk you’re comfortable taking in your financial planning. Obviously, that’s a tough nut to crack. We don’t really have a standard unit of measurement for risk, after all. So, what you end up with is a numerical score that corresponds with a few sentences describing the way the calculator believes you feel about risk and money.

Is that valuable information? For some people, it might be. There are undoubtedly a few folks out there who aren’t big fans of introspection who’ve never considered whether they’re devil-may-care or risk aversive. Those horoscope-like explanations of what the results mean might give people a slightly better sense of what their feelings really mean in some senses.

In those ways, you could consider the risk assessment tools valuable. They also have some potential value if you find that your attitudes about risk are in direct conflict with your optimal personal finance objectives (more on that later).

When Fear Shouldn’t Be a Factor

Even though there is some value in calculating your risk tolerance, you shouldn’t fool yourself into believing this information is truly mighty. Don’t make the common mistake of assuming that your comfort level should dictate your resource management.

That’s right, the argument that you should only invest at a risk level compatible with your own comfort level is wrong, wrong, wrong. If you’re tolerance for risk is out of whack (in either direction), you don’t necessarily need to change your investment pattern. You need to adjust your attitude instead.

That argument assumes an optimized investment plan, of course. The argument is quite simple. You should be following the best possible system to reach your financial objectives. If you are using that system and your personal sense of risk tolerance runs contrary to it, you need to change your attitude, not your plan.

Not everyone agrees with that. Statements like, “Your risk tolerance should determine a suitable asset allocation that is right for you” are common. There’s a belief out there that you shouldn’t invest if the move makes you uncomfortable. That’s a backwards perspective, though.

Smart Investing

You should be focused on developing a plan of action that will meet your needs and objectives. If you can do that while staying in your psychological “comfort zone”, that’s great. If, however, it moves you into uncomfortable territory, you need to change the dimensions of that “comfort zone”.

Otherwise, you’re setting yourself up for a long-term failure. If you need to undertake a certain level of risk to reach your goals, anything short of that is going result in you falling short of those goals. If the plan is sound and the strategy is workable, you should be at least somewhat comfortable in knowing you’re doing the right thing. If you don’t feel that way, it’s time to either (a) persuade yourself to start or (b) prepare to be nervous for a while.

InvestorGuide.com lays out the argument:

We need to remember that it is not only our personal risk tolerance that we want to consider, but we also want to ask ourselves, “What is the appropriate risk to take?”

Asking how you feel about something is wonderful. Letting the answer dictate your personal finance strategy, however, isn’t. Instead, you should be making decisions based on your own financial interests.

If you don’t have a good plan and you’re living on a personal finance roller coaster, it’s fine to take stock of your comfort level and to act accordingly. If you’re following the kind of smart plan you need to get ahead, however, your comfort level needs to take a backseat.






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Comments to Risk Tolerance and Smart Investing

  1. I just became introduced to the concept of “Alpha” which measures your return after considering the risk level (“Beta”) of your investments. Long-Short mutual funds are a way of creating Alpha and giving you upside appreciation (the long part) with downside protection (the short part). Would have been nice to have been exposed to this concept about 18 months ago…. http://ratenerd.com/long-short.....-fund-1456

    RateNerd


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