Risk tolerance is an often overlooked factor and misunderstood by the common investor. An investor may believe that he is comfortable with a certain investment and can handle X amount in losses. However, people tend to underestimate their risk when the stock market is flying high, and to overestimate it when the market heads south. In other words, when times are good, investors believe that there is not much risk, since everything seems rosy. On the contrary, when there seems to be no light at the end of the tunnel, investors tend to think there is tremendous risk involved.
Before putting any money to work, we need to sit down and analyze how much we are truly willing to lose without panic selling and running for the exits. For example, from the highs of 2007 to the lows of March of 2009, the stock market tanked over 50 percent in value. A large portion of investors panicked and sold at the low end of the spectrum. They feared that this was the collapse of the stock market and they could lose an entire life's savings.
If an investor analyzes his risk tolerance correctly, he will honestly answer what portion of his investment he is willing to lose without panicking. Let us assume that an investor is only willing to lose 25 percent of his total investment. We can fairly assume that in a worst case scenario, the stock market may lose around 50 percent of its value give or take. With these two variables in mind, we now know that our investor should only commit 50 percent of his capital into the stock market, and let the rest work in safe investments such as bonds. Our investor will now be able to have a peace of mind, and this is especially important in the retirement time period. He now should truly be comfortable with staying in the stock market, knowing that at most he will lose 25 percent of his investment in a bear market cycle. This prevents the dreaded uncertainty of losing it all, and selling near the lows when our threshold for losses has been reached.
The main concept our investor needs to realize is the swings he is potentially putting himself through. Can you handle losing 1 percent of your investment per day? Are you able to sleep at night with the uncertainty of losing 50 percent of your capital? For the most part, risk tolerance tends to go down with age. This is simply due to the fact that our older investor has less time to work for the most part. Hence, he is now, or will soon be relying on this income as a steady source of income. On the other hand, our younger investor has more time to make up these losses, and will not be relying on the stock market as a primary source of income to pay bills and various expenditures.
Let us analyze swings of two giants in their industries: Netflix (NFLX) and Green Mountain Coffee Roasters (GMCR). The 52 week range of Netflix has been a low of 52.81 to a high of 197.62. Netflix was hit hard from March of 2012 to August of 2012 as the company announced a price increase of nearly double in their services. Ironically, the stock price dropped almost in half from just over $100 per share to under $60 per share. Worries about competition and the price increase settled into investors minds. Many believe that a large portion of customers would now be lost due to this decision. However, as time went on, the stock began to slowly recover to reach 197.62. Investors who simply did not have the proper risk tolerance to withstand such swings were forced out of the market, and are now kicking themselves for their improper management of risk. If a smaller portion of capital was invested in this position, the investor would most likely have felt comfortable with the loss and may have even bought more to average out the position.
Similarly, Green Mountain Coffee Roasters has exhibited large swings that have pushed the unsophisticated risk manager out of his position. Its 52 week range $17.11 to its high of $57.57 was attributed to accounting fraud accusations by hedge fund manager David Einhorn. Einhorn was successful in convincing investors to get out of the stock and to short it. As time went by, the patient investor who had faith Green Mountain was able to regain value. The company's mindset of expansion and the enormous market share potential to capture much more is extremely favorable for the future outlook. In both cases of Netflix and Green Mountain , the investor who could not handle more losses panicked and lost out on the strong come backs that were inevitable with these giant companies in the midst of global expansion.
A thorough analysis of risk tolerance is often overlooked in investing and a true evaluation or simulation should be taken before large investments are made.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.