What is the biggest loss you would be willing to tolerate before you change your long-term investment strategy?
What would shake you?
How committed are you to your course of action?
In order to make investing more appealing to the regular investor, the financial services industry has conjured up multitude ways to promote and market investment options to the general public.
What’s left out of this discussion very often is the prudent amount of risk a long-term investor is willing or needs to take to reach their long-range financial goals. And instead of having a realistic and thoughtful discussion about risk tolerance, many investors and many financial advisors get caught up with pondering the benefits of the latest mutual fund flavor of the month or the seemingly endless new supply of ETF’s that seem to increase exponentially each passing week.
Don’t get me wrong, some of the new investing options, especially some of the newer ETF options that have recently been introduced, especially Vanguards ETF offerings are pretty outstanding. That said, before making any decisions on which funds to choose for your investment strategy, I suggest it’s more crucial to first understand and recognize how best to manage your investment risk.
Mastering the Art of Risk Management
In principle, the less sensitive you are emotionally to small fluctuations in the value of your investments, the better off you’ll be in the long run. Yet, as we all know, this is much easier said than done.
The real culprit that can sabotage your ability to reach your long-term retirement goals is very often the fear of losing money, also known as loss aversion, the first cousin of risk aversion. Investors that have a tendency to overreact emotionally to losses as well as gains are much more likely to feel disempowered instead of feeling empowered.
It’s that fear of loss that kicks the primal reptilian part of our brain into action. Fight or flight is our unconscious conditioned response to this fear that’s pumping through our body. Rational thought gets thrown out the window, our emotions take over and all too often, major financial decisions are made in a state of panic.
To begin learning how to master your emotions when it comes to investing requires you to truly understand your appetite and tolerance for risk. A good place to begin this exploration is by asking and reflecting on the three questions at the beginning of this article.
The more you truly learn and discover about yourself, the more honest you are about taking on risk, the better aligned your investment strategy will be with your acceptable risk level. If you already know that you’re someone prone to strong emotions when it comes to investing, then taking as little risk as needed to reach your financial goals is your winning formula.
Deciding on the right amount of risk to meet not just your financial goals but your emotional temperament as well is a process of trial and error. On paper, filling out a risk questionnaire that describes possible what-if scenarios and decisions you would most likely make in each situation is one thing. Holding steady, staying the course, sticking to your strategic investment plan when markets are highly volatile, well, that’s a whole other dimension of risk taking.
When is Enough, Enough?
Taking on more risk is a strategy for maximizing your wealth. The more risk you decide to take, the higher the potential return will be. Yet ultimately, what this all boils down to is a trade-off between personal comfort; being able to sleep at night through the markets ups and downs and taking the appropriate amount of risk needed to reach your long term goals.
It’s a balancing act for sure, one that requires lots and lots of practice and honest self- evaluation before you’re able to achieve mastery. Yet the investment of time you make will reap dividends and rewards greater than you can possibly imagine.
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