Understanding And Managing Your Risk Tolerance In Investing
Let’s say someone offers you $100,000 to cross a busy highway blindfolded. Would you do it? Probably not, unless you knew for sure a loan shark would break all your ribs and cut off your pinkies if the money you borrowed was not returned by 9pm that evening. You now have to weigh between potentially getting hit by a truck and dying, or the certainty of feeling intense pain during a long stay in the hospital. Once you’re healed, the loan shark will be waiting for you since you’ll still owe $100,000!
We do not know what we do not know. Therefore, it’s important to run through different scenarios when it comes to investing and planning for your retirement. I put my 401k through three different scenarios of Base Case, Realistic Case, and Blue Sky Case to see whether there will be enough for me to live on by the time I’m in my 60s. Everybody should do the same because it’s better to end up with too much than too little. The reality is that I’ve mentally written off my 401k completely so I can stay hungry and build further income streams.
Now that the stock markets are at 5-year highs, I’ve received a lot of feedback that we should all be heavily invested in stocks. It’s terrific how short our memories are when it comes to investing. Take a look at the commentary from my recommended net worth allocation post and see for yourself. It’s as if 2009 never happened. The best is when someone who only started investing after the crash, or who hardly had any money during the crash tells me he’s so bullish on the markets. The enthusiasm gives me hope that we will repeat the same mistakes over and over again. Only through enough pain do we change our ways.
EVERYBODY IS A GENIUS WHEN THE MARKETS ARE GOING UP
There’s a great saying on Wall Street, “Bulls make money, bears make money, pigs get slaughtered.” The phrase is used to counsel against excessive greed and impatience. An Anderson Consulting recruiter uttered this phrase to me back in 1999 after I bragged about how great I was doing in the markets that year.
At the age of 21, I thought I was an investing genius even though I didn’t even know how to properly analyze a balance sheet. I turned the $2,000 in my Ameritrade account to over $8,000 in just six short months after trading stocks like Books A Million (BAMM, still my favorite ticker of all time) before its takeover, Macromedia, and TDFX Graphics. A 400% return put me in the top 0.1% of investing returns and I proudly walked around the dorms as if I owned the place.
My greed got a hold of me and I kept trading stocks between classes until I lost half my entire portfolio. With $4,000 still in my account, I figured 100% was still a great one year return. I mistakenly extrapolated that managing a $4,000 portfolio was the same as managing a $4 billion dollar portfolio. I carried my arrogance into my interview and to nobody’s surprise, I didn’t get the job.
I’m witnessing the same type of bravado now as I did back in 1998, 2000, and 2007. There’s a strong false sense of invincibility investors have with their investments now that the good times are back. If you’ve been following my site since 2009, you know I’ve been as positive as they come (Read “Am I Living In A Parrallel Universe Because The Economy Looks Fine” from July 17, 2010). However, to have the majority of your net worth/retirement savings in the stock market is ridiculous. It’s as ridiculous as a guy willing to walk across a highway blindfolded for $100,000.
MAKE SURE YOUR INVESTMENTS ARE CONGRUENT WITH YOUR RISK TOLERANCE
When I revealed that I recently took money out of stocks and into bonds when the S&P 500 hit 1,525, I was criticized. I don’t mind being criticized if you buttress why you think the way you do. However, the person in question asked why I would buy bond yields at all time lows. I scratched my head because the 10-year US Treasury yield’s all-time low was last August, 2012 at 1.4%. When I rebalanced some of my equities into bonds, the 10-year yield hit 2.05%, a 47% increase since last August. Meanwhile, the S&P 500 gained 6.5% in just 1.5 short months. Everything is relative when it comes to investing.
As I wrote in my 2013 predictions, I expect 10-year Treasury yields to close below 2% for 2013 and the S&P 500 to climb 8.8% to 1,550. Whether I’m right or wrong, only time will tell. However, what I am doing is actively managing my portfolio based on my laid out assumptions. With the 10-year Treasury yield above my 2% target, and the S&P 500 only 2.3% away from my year end target, of course I’m going to reduce my exposure.
There are actually people out there who spend zero time coming up with an investment framework. All they do is invest in stocks like brainless zombies. Blindly following investment advice or following the herd isn’t a great idea. Please, if you are going to put your hard earned savings in someone else’s hands, come up with your own thoughts! Nobody knows the future, which is a given. But if you don’t know the future AND you don’t know your risk tolerance, then you are really setting yourself up for failure.
I continue to believe a strong multi-year recovery in housing is the underpinning of a recovering economy. Just remember that stocks and bonds discount events in the future. Your number one goal once you’ve built a sizable portfolio is to not lose money. Make sure your portfolio reflects your risk tolerance.
* Why do people who haven’t experienced downturns think they know better than folks who have experienced upturns and downturns?
* Why do we think our risk tolerance is the same when managing a $10,000 portfolio vs. managing a $10 million dollar portfolio?
* Why do we think we know what we don’t know?
* Does anybody ever lose money when they are posting on the internet? Or am I the only one?
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