The level of financial risk we can tolerate depends on our savings: The less money we have the more risk we can afford to take on. If you have worked with a financial advisor before then you’ve probably seen a risk tolerance chart like the following.
Each portfolio from A to D represents a different risk tolerance of maximum expected returns and losses. Choosing a model portfolio can help one’s financial advisor determine the best funds for the client based on his risk assessment. Conservative portfolios tend to hold more bonds, GICs, and T-Bills. Aggressive portfolios may hold more technology and energy stocks, which are more risky but also more potentially profitable.
If we are currently in our working years and only have $100,000 of savings, then we should have an aggressive investment plan that mimics the expected rate of return as Portfolio D in the image above. High risk, high reward. Like Ms. Frizzle always says, “take chances, make mistakes, get messy!” This is because losing $20,000 in the worst case scenario is no big deal since we are still actively working. $20,000 is only 6 months worth of salary for many people, so the loss can be quickly recouped 😀 But if things go well then hot diggity dog! we’ll make a $50,000 profit. The key to compound interest is to start as early as possible so if we can make our portfolio value 50% higher at a younger age it will give us a huge advantage over the long run.
But if we have recently retired and have $1,000,000 in savings then our investment goals would be different. We can’t be in Portfolio D because a potential $200,000 loss is a lot of money, and could prevent us from having a comfortable retirement. At the same time the potential return of $500,000 doesn’t sound that appealing when we’re already millionaires. At a certain level of wealth any extra money we save will face diminishing marginal utility which means the lifestyle of a senior who is worth $1.5 million isn’t going to be drastically different from another senior with only $1 million. So in this situation it would be better to choose the more defensive Portfolio A.
When we’re young our spending often depends on the product of our human capital and time, both of which we have an abundance of. But when we’re retired our human capital becomes diminished, so lifestyle needs to depend on our savings instead. This is when capital preservation takes priority over investment returns and we have to decrease our exposure to risk in order to make our portfolio last as long as possible 😉
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Random Useless Fact:
Humans don’t have natural enemies. So we fight with each other.
In theory yes, but in real life, many people allow their emotions to either control their investment decisions or affect their investment decisions.
When the market crashes, people tend to panic and pull out the market – an action dictated by their emotions/fear of loss. Logically, this is the worst decision to take. But emotions are a powerful dictator of behaviour for the masses.
People need to become informed and educated investors before they take on “risky” investments and portfolios. Or else they will most likely fuck it up!
I agree. Understanding one’s own emotions is paramount to becoming a good investor, regardless of risk tolerance 🙂
I agree with Kapitalust. Theory is one thing, reality is another thing. People behave and think differently when they’re mixed in their own emotions.
Yup, I think Ben Gram once said “individuals who cannot master their emotions are ill-suited to profit from the investment process.”
Like the others above have mentioned, this is how it should be. Too bad most people don’t stick to a rational investment approach. A problem I think often occurs is greed. An extra $500,000 sounds so tempting, even when you’re already a millionaire!
It’s easy to overestimate your risk tolerance until it’s too late and you find out you can’t stomache the loss!
I have fallen victim to my own greed in the past. I have to learn to make better informed decisions.
I would have to agree with the previous comments. Emotion plays a large role in making money decisions as well as greed. Those two are probably the biggest obstacle to overcome when creating a rational investment plan.
I also think emotions and greed around money are what cause a lot of strife in relationship.