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Has Your "Risk Tolerance" Been Tested?

|Includes: DIA, QQQ, SPDR S&P 500 Trust ETF (SPY)

Summary

Most investors are asked to define their "risk tolerance" when they have no true understanding of what their risk tolerance actually is.

It's impossible to understand your true risk tolerance until it has been tested.

Learn from the mistakes of veteran investors who have paid for painful lessons.

Most early-stage investors are asked to define their "risk tolerance" when arriving at an asset allocation.

"Oh, yeah, I can take market downturns," says the typical young or aggressive investor, trying to make up for paltry investment sums with outsized gains. "Put me in 100 percent stocks, or 80 percent stocks, or 70 percent stocks."

What happens to such investors? The veteran among you know all too well: they sell at the bottom. And they start buying again near the top. 

Why? It's not because of some personality flaw that makes them less than others. It's because no one can really define one's risk tolerance until one has actually gone through bear markets and taken away the painful and costly lessons that they provide.

Let me use the example of a 48-year-old banking professional who, prior to the 2008 market meltdown, considered himself to be an investor with a "high" risk tolerance. Believing himself to be both experienced and prudent, he had a portfolio that was 80 percent stocks, indexes, going into 2008. He had stuck with his portfolio through a few scary downturns--dot-com bubble and Asian crisis, as well as numerous other mini crashes--so he considered himself seasoned. He didn't bother to adjust his asset allocation as he aged because, frankly, he had lived with the 80 percent allocation to stocks for long enough to feel like he was a tough guy. He felt good about his job. He had years to go before retiring. He had a family, a house, etc. He was counting on the heavy stock allocation to see him into and through retirement.

Then, of course, 2008 happened, and his risk tolerance was tested, really tested, in ways he never imagined. It wasn't just the dollar amount of losses that he experienced. He also lost his job. His relationship buckled under the weight of the ensuing financial strain, and the marriage collapsed, leaving him with the stress and expense of divorce proceedings. He had a mortgage on the house, as most people his age do, but the loan quickly took on water, just as he needed to sell the place to finance his living and divorce expenses. 

And, oh--about that risk tolerance? Well, in the face of all of the other losses, he couldn't stand to watch the value of his hard-earned money continue to fall day after day. So he did what many who have never had their risk tolerance truly tested do: he sold, near the bottom, cashed out much of the account, and did not get back into the market until 2014.

So what's the lesson here? It's about an incomplete understanding of the term "risk tolerance" that led to an inappropriate asset allocation for this man. What would have been a better asset allocation given this man's risk tolerance? 

I'm going to pose both this question to the community and ask a favor, as well, so that the community can learn from the experience of others: Has your risk tolerance really been tested? If so, how did the test cause you to alter your asset allocation?

Thanks in advance, and see you in the comment section.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.