Increasing one's ability to tolerate investment risks can allow the investor to successfully take more compensated risk for which he will likely be rewarded with higher long-term returns. Here are six strategies to build risk tolerance.
An investor should consider his need, desire, and ability to take risk when determining his portfolio asset allocation. However, there are times when an investor has a desire, and perhaps even a need, to take more risk than he currently has the ability to tolerate emotionally or even fiscally. Increasing his ability to tolerate investment risks can allow him to successfully take more compensated risk for which he will likely be rewarded with higher long-term returns. Thus, the ability to increase risk can be extremely valuable, worth perhaps hundreds of thousands, or even millions of dollars over his investment career.
Before discussing the various ways to increase risk tolerance, it is important to understand how devastating to your investment performance exceeding your risk tolerance can be. This is usually an investment disaster, as it typically manifests itself with a “sell low” phenomenon at bear market lows. It is far better to estimate your risk tolerance a little low, and be a little short in retirement, than a little high, and end up very short in retirement. If you have not yet invested through a bear market, such as the 2008-2009 Global Financial Crisis, you would do well to consider yourself an investing virgin. Estimate your risk tolerance as best you can, then back it off a little. You can increase it later if it turns out you are able to tolerate more risk than you thought.
Here are six ways you can increase your risk tolerance.
1. Emergency Fund and Short-Term Savings
Having an emergency fund of three to six months’ worth of living expenses and short-term savings to cover any large upcoming expenses allows you to tolerate investment volatility and loss simply because it is not money that you need any time soon. I completely understand why someone who has invested next month’s rent in Twitter would lie awake at night.
2. Income Diversification
Some careers provide more stable income than others. Physician careers tend to be on the more stable side of things, allowing the physician investor to tolerate more risk since he is unlikely to lose his job in a bear market as a tech worker might. In addition, diversifying your income with a second job or entrepreneurial pursuit allows you to have even more secure income, again increasing your ability to tolerate investment-related risk.
3. Understand Investment History, Theory, and Expected Performance
Many investors have limited understanding of their investments, the past performance of those investments, and expected future performance of those investments. History may not repeat, but it certainly does rhyme, and an understanding of what markets have done in the past dramatically decreases the likelihood of panicking and selling low when something similar happens during your investing career. Even simple facts, like knowing that on average equity markets lose 10% every two years, 20% every five years, 30% every ten years, 40% every twenty-five years, and 50% every fifty years can be very comforting. If the future resembles the past, an investor with a 60-year investing career (30 years before retirement and 30 after) should expect to see 30 corrections, 12 bear markets, two to six big bear markets, and one or two real whoppers.
Similarly, some investors view the stock market as akin to a casino, not connecting the fact that their returns are coming from the real profits made by real companies whose products they use every day. The long-term returns of stocks come from dividends and a growth in profits. In the short term, there is also a speculative factor, but that zeroes out over the long run. The long-term returns of high-quality bonds come from the dividend payments, although changes in interest rates can affect short-term returns. Knowledge of these facts allows the long-term investor to ignore the vast majority of business-related news since it mostly deals with short-term issues.
4. Understand All the Risks You Face
Too often a misinformed investor has low risk tolerance because he has only considered the volatility of an investment. This short-term risk can almost be ignored by a long-term investor. The real risks to a long-term investor are inflation, deflation, confiscation, and devastation. Another risk that too many “conservative” investors ignore is shortfall risk, the possibility of their portfolio not meeting their retirement income needs due to inadequate savings and low returns. Many investors haven’t run the numbers and realized just how much of their gross income they need to save if they invest conservatively. For instance, an investor who wishes to work and save for 25 years and then wants his portfolio to provide 60% of his pre-retirement income, but who is only willing to invest in conservative investments that only beat inflation by 1%, will need to save 53% of his income each year for those 25 years. Taking some more investing risk is probably a more appealing option once he has the facts.
Financial theorist William Bernstein, MD has said: “There are no free volatility-reducing lunches that will inexpensively reduce your portfolio risk, and there is no risk fairy to insure the risky parts of your portfolio on the cheap. Yes, there are people who—and vehicles that—will do this for you, but they will cost you a pretty penny.”
Taking too little risk has real consequences on how much you need to save, when you retire, and what your retirement will look like. In fact, Phil Demuth, PhD, has argued that risk tolerance perhaps should not even be measured.
He said, “Even if risk tolerance existed and could be measured accurately, why would it be an important factor to consult when considering how to invest? You should invest in the way that has the greatest prospect to fulfill your investment goals. That might mean taking more or less risk than you would prefer. If you are a sensitive soul who can brook no paper losses, the solution is to get a grip, not to invest ‘safely’ if that locks in running out of money when you are old.”
5. Develop Entrepreneurial Skills
Entrepreneurs become experts in risk management. They have to, because the risk of failure is so high for new companies. Some of the most risk tolerant investors I know are those who have started their own companies. Not only do they have a better understanding of how businesses work, but the risks of stock market investing seem to pale in comparison. The entrepreneur looking at a total stock market index fund thinks, “Wow, I own parts of 5,000 companies. They’re not all going to go broke at once. That doesn’t seem risky at all!”
6. A Change in Attitude
In a market downturn, some investors focus on the losses occurring rather than the opportunities those market declines may represent. Market drops are a great opportunity to buy low with new contributions to investing accounts. Rebalancing a portfolio, where you sell assets that have done well and buy those which have lagged over the last year, also forces you to buy low, controlling risk and perhaps boosting long-term returns. A successful taxable (non-qualified) investor sees a market decline as an opportunity to tax-loss harvest, where he exchanges investments, booking a loss he can use to reduce his taxes, without being out of the market and missing the inevitable recovery.
Following these six steps is likely to increase your emotional and financial risk tolerance, allowing you to take on more compensated risk and thus likely enjoy higher long-term returns.
Dr. Dahle is not an accountant, attorney, insurance agent, or financial advisor. He blogs as The White Coat Investor and is the author of the best-selling .