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The risky business of misjudging your risk tolerance

Mar 09, 2020 | Andrew Ielmini


Riskier than you should be? How misjudging your risk tolerance can prove to be very costly.

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As the ever-eloquent Mike Tyson once pointed out, “everyone has a plan until they get punched in the mouth.” Tyson’s statement provides some surprisingly great insight into your own risk tolerance as an investor.

Whether you invest on your own or you have a whole team of financial advisors, you’re probably familiar with the concept of risk tolerance. Most wealth management firms assess risk tolerance through a combination of pointed questions and statistical analysis, although the conclusions typically require a combination of both art and science. It is important to realize questionnaires will only provide part of the picture. Getting an outside perspective from someone who has gotten to honestly know you is important and the mix of both may help you avoid costly missteps.

It’s extremely important to accurately understand your risk tolerance as it helps shape your financial plan. Misunderstanding how risk averse you are can lead to everything from heartache and sleepless nights to an impaired retirement.

As you can imagine, one of the biggest problems is that people often misjudge themselves. Can you blame them? When confronted with different scenarios, it’s only natural to outweigh the positive possibility over the negative possibility. Who doesn’t want to earn a better return? It’s hard to truly know how loss averse you are until faced with actual losses, or in other words, you think you can handle the losses until you get financially punched in the mouth.

Misjudging your risk tolerance could prove to be very costly, but fortunately there are ways to more accurately determine your risk tolerance.

  1. Be honest with yourself. Look back at how you reacted in situations when your portfolio might have been negative and try to recall, not only how you reacted, but also how you felt. If you were constantly checking your investment account balance or refreshing the market news, your risk aversion may sit at the lower end of the spectrum.

  2. Consider your time horizon and your objectives. What kind of expenses will you have in the short term? How long can you afford to let your money ride out a downturn? Based on your time horizon, what kind of returns will you need in order to achieve your objectives?

Your self-assessed risk tolerance might lead you to believe you have a big appetite for risk. An appetite which leads you to order that double cheeseburger when you should’ve just eaten a salad at home. The problem becomes that it shapes unrealistic objectives, turning luxuries into necessities, which only compounds the problem.

As mentioned earlier, be honest about what level of risk you’re comfortable with but also realizing that quantitative questionnaires will only provide part of the picture. Getting an outside perspective is possibly the most imperative. Make sure to communicate openly and honestly with your financial advisor and be open for their counsel and feedback. You want a financial advisor who will be honest and let you know when you’re setting unrealistic objectives which will push you out of your risk tolerance comfort zone.

In an era where technology has all but removed personal touch, rather than getting to know the person and truly understand them, these questionnaires are often the sole foundation upon which your financial future is built. Instead, your risk profile should act as a starting point, a conversation starter into getting to know you, the person behind this score. You are unique, which demands your solutions must also be—don’t build your future on a misplaced foundation. Get to know your advisor and make sure they get to know you.

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Wealth planning