Understanding And Managing Your Risk Tolerance In Investing

Jump in. The water is freezing.

Jump in. The water is freezing.

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.

Discussion Questions:

* 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?

Regards,

Sam

I manage my risk by knowing where my assets are with Personal Capital. Click the banner to sign up for free.

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    I would never put all my money in stocks. I’ve lost money myself thinking I actually knew how to time the markets, and I’ve seen even the most experienced portfolio managers get blown up. I’m not saying investing in stocks is a terrible idea, but it shouldn’t be 100% of anyone’s investment plan. I agree that it’s easy for people to think they know what they’re doing when the markets are going up. Invest long enough and it becomes obvious that isn’t the case.

  2. David m says

    Why do we think we know what we don’t know?

    I love that question! It amazes me to hear people that have no knowledge predict the ups and downs of the market. I will admit that I have NO idea were the market is going. It may not be smart but when it comes to investing I’m like Ron Popell, “set it and forget it”.

    You have been so accurate in your last 2 years prediction posts, I feel like you really do know we’re the market is going. Why don’t you open up a hedge fund and I’ll invest in it!

  3. says

    If you haven’t experienced any downturns, you haven’t been in the stock market very long! I am probably more sensitive to stock market volatility as I get closer to retirement. I also think it is more characteristic of older people as they realize, they do not have time to make the money again. I am not switching to 100% bonds, but I am getting more conservative. Part of maturity is knowing what you don’t know.

  4. says

    I lost money before. I even wrote a post detailing some of my bad investing decisions.

    I am in all stocks at the moment, as I feel that dividend growth investing is the best way for me to hit my goal of financial independence. Real estate is probably worth reconsidering if I move to a different area in the future. I try to vet every stock purchase pretty thoroughly before making it. Plus, I have an overall investment plan that I try to follow. Since almost all of the stocks I own managed to maintain and even increase their dividend payouts throughout the Great Recession, I feel pretty comfortable with them.

    I’m also currently in the process of trying to learn more about non-stock investments that can provide income and may be a good fit for my portfolio.

  5. says

    I find it facinating that most people are investing in the US equity market. It’s a scary place right now. No one can explain the recent bull run-off. Every headline says that it’s because of x, y, or z. Am I the only one who recognizes that we are in a false economy? That the fed has been buying bonds with money that we don’t have, which goes into the economy to create even more money that we shouldn’t have? I have no clue where to put the majority of my hard earned money right now. It certainly won’t be in equities until the powers at be decide to get their heads out of their asses and fix this mess of a overspending, high debt society we’re in. Real estate, maybe?

    • Shaun says

      I think you need to research a little more about what money is exactly. Money’s created and backed by the govt with the penalty for too much creation being inflation. There is no amount of money that we do or do not have as a nation since if we had/wanted to we could just create that money tomorrow(proof being trillion dollar coin talk which was real). As long as the US is seen/has the worlds strongest govt/economy there will be a demand to buy bonds and they will continue to be paid. I repeat collapse is not imminent and with the sequestration happening you may find bonds react better than the S&P over the next month or so.

      Real estate is a good choice if you’re espescially worried about govt created inflation.

  6. says

    I love the anecdote with your 21-year-old stock trading. I went through a similar phase where I made a healthy bit of money and thought I was some sort of Ameritrade financial wizard. If I was smart, I would’ve been learning to live frugally and putting that money to work over a longer period of time with things that would now be generating me a ton of passive income. But, alas, you live and you learn! My wife and I have 401(k)’s, a rental property, and I’m building assets in Lending Club. Now that I’m obsessed with building assets, we’ll find more growth opportunities the more income we’re able to pile into things. Nice post!

  7. says

    I started investing in August 2007. Once I had saved up enough to meet the minimum buy-in, the first fund I invested in was the S&P 500 index. At the time we were starting to save up a down payment for a house too so I soon realized I should have it in bonds instead. As I watched the index fall, I thought “if it just goes up to $x then I’ll switch it over to bonds”.

    Now that it is close to reaching that level, I’m thinking that bonds would be a terrible place to invest. I was happy to buy stocks in 2008 as the market was going down (I ran out of extra cash before 2009 unfortunately) and stayed in for the following years which made me look good. 2 years ago I had 20% in bonds, but since yields have continued to fall and we keep getting further away from the recession that dragged those yields down I don’t like the payoff they offer and I don’t want to spend my time shopping around for the few bonds that are worthwhile.

    In contrast stocks have risen a lot but they are still aren’t overpriced like they were in 2000 or 2007 unless you expect the economy to collapse. There are two ways things can go. Either people decide the stock market is safe now and they rush back in, driving up prices another 10-50%. At that point I hope bond yields will have risen enough to safely move into them (since everyone will be selling off their bonds to buy more stocks). Or we get hit with another multi-year wave of fear and the stock market crashes. In that case we get to buy stocks on the cheap since we are already pumping in a lot of cash every month and it will buy more if prices fall.

    The only bad outcome for me is if the stock market continues to rise at this pace while bond yields fall further. I hope investors aren’t that irrational.

    • says

      It’s funny how now that we are back to 2007-2008 levels, your do over is no longer interested in bonds. Yes, yields have come down since then, but so has equity returns.

      I’m willing to bet that if stocks go up another “10-50%,” you still won’t be interested in buying bonds if 10-year treasury yields rise to 3.5%. It’s the way human nature is. We always want more, until we get pummeled, like the stock market did today 2/25/13 -220 on the Dow w/ bonds surging.

      • says

        When bonds yielded 3.5% I had 20% of the portfolio in them. It wasn’t a great yield but they kept delivering a 7-8% total return like they have for the last 5 years – until last year that is when the total return was half of that. 2 out of the 3 stock indexes I track have a dividend yield higher than those bonds.

        Sam, you say you see a lot of signs that the economy is doing well and people are spending. Do you think corporate profits will fall and inflation will stay low with those conditions? Even if you don’t I understand that you might like bonds because they have “predictable losses” and that’s good enough for you. For many people 2% per year over the next decade isn’t enough.

        But you don’t have to tell them. After seeing the last 2 months of stock market action I’m sure they’re getting ready to buy once prices go up a bit more. At that point I will truly be scared of stocks.

        • says

          There is so much economic slack that I seriously don’t see inflation ticking up much.

          I’m not buying bonds for a 2.05% return to maturity. I’m buying them for principal appreciation and perhaps a 2.05% yield when the stock market implodes like today.

          What’s your portfolio position now and for the year? Thoughts on SP500 returns for 2013?

        • says

          Current portfolio is 30% Canadian, 31% S&P 500, 34% EAFE, and 5% fixed income (of which 2/3 is in medium-term bonds and 1/3 is in high yield mortgages currently producing a net 5%). This year I’m adding a few ETFs which may include a bit in REITs and emerging markets. Otherwise it will only change if the market opportunities change. If anything drops nicely this year I’ll move more into that. I don’t know what will happen this year but I believe all 3 stock indexes (including the S&P 500) will turn in a decent but not exciting return over the next 10-20 years.

  8. says

    I was an investing genius my Sr year of high school when my dad let me open a trading account with my savings at that time. I tripled my money and thought I was invincible, and then lost nearly everything when the tech bubble burst a few months later.

    The herd mentality in the investing community never ceases to amaze me. Where were all the pundits and articles telling you to pile into stocks in 2008-9? Because they’re all over the place now, which seems kind of backwards if you ask me.

    • says

      The herd is much more concentrated in being 100% in equities now. This is from my observations in the media, comments on my site, and discussions with friends. When you have folks with no idea what they are talking about promote specific stocks, things get scary.

  9. says

    I had a very similar story when I started investing which I recently shared in my 5 Trading Mistakes That Make You Look Dumb. You think you know everything, when you don’t know anything.

    I think that a little information is dangerous – it makes you think you know how to. Plus, I think success early on is almost more detrimental than failure, because it will give you a false sense of power/knowledge.

    In the end, the smartest finance guys are the ones taking the commissions for not doing any work or risking any money.

  10. Mike Hunt says

    I’ve certainly lost money in the market before. I was lucky to leg into a few telecom infrastructure stocks in Nov 2012 and I sold out at the beginning of this month making a nice 43% profit- was happy to book at and sit on the sidelines for a while with a lot of cash earning nothing. Sure the market could go up a good bit more but it is already at 5 year highs as you say- I am not worried about missing this opportunity in the short term.

    I like a balanced dividend stock portfolio, but would like to get into this at more compelling valuations. I am happy to wait until the time is right.

    -Mike

  11. says

    I am broke and late to the retirement savings party and that always makes me think that I need to take risks but I am trying to remember that I don’t really know anything.

    A thought changer for me was your post Net Worth Allocation By Age And Work Experience. You said how do I think I know more than everyone else. I was in the bottom (older half) of the charts and I can’t afford to take as much risk because I am too old.

    Your post came on the same day as Boomer And Echo’s Can You Succeed With An All GIC Portfolio. I was considering a new, risky, chance of a high return investment when I read the two posts. I think it was the universes way of telling me something.

    I wrote a post called Too Old To Gamble Or Too Poor Not To Try about my conflict.

    Not trying to advertise my own blog on your site so please feel free to delete this comment if it seems that way to you.

    • says

      It is always good to remind yourself what you do and do not know. I read your follow up post and I do not think you can afford to gamble. Instead, I would just accept the fact that working longer is an inevitability. See if you can leverage your blog for some income perhaps.

        • says

          I think you’ll be surprised how much you can earn online if you really focus on your site. Google the Yakezie 5,000 Word Challenge we did last Winter that provided a slingshot for higher traffic and rankings to those who participated. Also check out the post on Yakezie.com entitled, “Is Internet A True Meritocracy?”

  12. says

    LOL! Investors and gamblers tell the same stories, don’t they? You never hear about when they lose. I love the saying about the bulls, bears, and pigs. Patience is key to any investment. If you are not prepared to keep your money invested, all you are really doing is gambling. Also, I agree that you need to have your own plan. It is your money, so be active.

    • says

      Hope you took my advice after today’s beat down in the markets and bond surge. The scary thing is when engineers start prognosticating the markets. Then things are really going to get dangerous.

  13. says

    Most people trading in the stock market don’t understand that they really need to be managing risk, not positioning for the returns. Listening to someone talk about their potential returns is like listening to a fanboy talk about why their football team is going to win the Super Bowl. They may make a convincing case, but they don’t really know. I think William Bernstein said it best, “the goal of investing is not to get rich – it is not to die poor.”

  14. says

    “Why do we think we know what we don’t know?” I LOVE this question. I saw it all the time in my working with retail investors and so often they thought they knew exactly what they were doing when they were actually throwing money out the window. I think all too often that investors believe they can just put money into stocks and overnight see it quadruple in value. Sure, that might happen once in a blue moon…but I am also as likely to get struck by lightning. I am sitting on the sidelines right now with a good chunk of cash waiting for it to go down and then come in. The investments I do have are doing quite well and am ok with that. I would also agree that housing is likely to lead our long term recovery and are starting to see some signs of that today.

    • says

      Retail investors are notorious for getting in late and leaving late. But, we can only really learn until we get a little slaughtered. Folks who are majorly invested in the stock markets got hit by a motorbike today luckily. The bus is still coming. It’s going to be exciting!

  15. CDP45 says

    Can you tell us what bonds funds you invested in or point out some bond funds that have benefited from the 43% increase in yields?

    I trust you Sam, and I do apologize if you took my comments regarding your bond allocation as criticism. I am new to the FIRE ideas so that’s why I am questioning you, in order to learn more, and I appreciate your time and wisdom you offer.

      • CDP45 says

        My apologies, you wrote 10yr yields have increased 47% single last August, so do you believe they will fall within the year? You said your target for the 10yr was below 2%, so how much lower do you think they will drop? I’m confused because there is a limit to the upside of bonds.

        I did share some of my positions and background last week, and I thank you for your interest in the students ideas when I am here to learn from the teacher.

  16. John says

    Given the fact that interest raise will rise in the future (although no one knows when) would it not be more prudent to to totally exit ALL bond funds to avoid losses?

    Minimal bond allocation can be maintained in terms of I-bonds which would tide over the inflation risk. I’m talking about a 35yr old individual

    • says

      No. Interest rates have been going down for 30 years in a row. People have thought this for years. Let me know the date or even month when interest rates go up so I can refinance and sell before then. Thx.

      • John says

        Sam, do you expect in the next 30 years interest rates will be lower or higher?

        No one knows when they will go up; but based on “reversion to mean” in the next 30 years they will at least head upwards for a while

        • says

          What is the mean when the world is always changing and financial regulation is becoming ever efficient?

          I don’t expect interest rates to rise materially higher for the next decade here in the US. If the 10year bond yield goes from 1.9% to 4%, that’s a doubling, but that’s still quite low. I’ll happily make a bet with you that the 10-year yield stays below 5% for the next 10 years. What would you like to wager?

          Also, please share with us your investment background, net worth allocation, and portfolio allocation between stocks and bonds so we can have more reference for where you are coming from. New comment is necessary.

          Thanks!

  17. says

    “Why do people who haven’t experienced downturns think they know better than folks who have experienced upturns and downturns?”

    They’ve never been hit while crossing the highway.

  18. says

    Great post Sam! I think we all succumb to pride and arrogance and that leads us to take risks that are unnecessary and unwise. I had a similar experience when I first began investing…thought I knew it all. It took me losing money to realize I didn’t. Only experience could teach me that.

  19. says

    Why do we think we know what we don’t know? Almost sounds like a Dr. Seuss quote. Wouldn’t life be so much easier if we studied the things we don’t know and were OK to admit we didn’t know them in the first place?

  20. says

    I think we’ve all thought we were the smartest guy in the room at one point or another, luckily for us the market has a way of humbling us very quickly. ;-)

    This is why I continue to educate myself because I came to the realization that perfection is an absolute myth, while we can strive for perfection and in return be the best amongst our peers, the end result will never occur. It’s absolutely impossible!

  21. says

    It’s hard to believe that people’s short term memories are so bad when we’ve had two 50% corrections in the past 13 years alone. People really to have a problem with recency in this country. Another way to look at your recent move is simply as rebalancing your portfolio. This simple tool that can be automated gets forgotten far too often when talking about investment moves to make. You can do it once or twice a year just to keep yourself honest and take your emotions out of the equation.

  22. says

    I have a hard time believing people simply forgot what 2009 was like. Rather, I think people are realizing that the primary risk with stocks is volatility, not much more. Every few years you’re going to have to swallow the lump in your throat and deal with a downturn, but recessions are luckily only temporary in nature.

    We’re all too comfortable with something. It’s easy to ignore the irrational exuberance of a real estate investor or small business owner because there is no perfect mark for his or her asset’s value at any given time. Stocks have an available mark every second of every day.

      • JayCeezy says

        LOL~! Yes, that is the positive side, FS.

        “People with positive attitudes just don’t have enough information.” – Lily Tomlin

    • JayCeezy says

      @JT, do you really think the primary risk for an investor is “volatility”? Over what period? Months? Years? How old were you in 2009?

      In 1989, 27 years ago, the Nikkei almost hit 40,000. Today, it is at 11,600. (Never mind that inflation cuts that nominal value in half) The FTSE is today at the same nominal level it was at in 1999. Same with the S&P 500, which constitues about 70% of the 7,700 publicly traded U.S. stocks. These are Asian, European, U.S. equity markets in the most stable economies in the world; these are not ‘Emerging Markets’ where the govt. turns over and the currency is devalued by 50% because the oligarch says so.

      The NASDAQ hit 5,000 13 years ago in 2000. It’s under 3,200 today, where it was in 1984, 29 years ago. btw, what year were you born?

      There was a book published by respected economist James K. Glassman in 2000, called“Dow 36,000.” The premise was exactly what you are saying: that there is no longer risk in equities, because stocks always come back from declines, and over decades-long periods they always increase. We all know how that has turned out, and Glassman spent a decade denying that he was wrong (“just wait!”), and the past 3 years “explaining” to us all the “things changed”.

      Well, I wish you well in your endeavors for blogging, and personal finance. The fact that you have an interest, and a plan, comes as close as you will get to a guarantee that your results will be far better than your peers from school who just let life kind of happen to them.

      • JT says

        The Nikkei is an extreme example, but worthy of discussion. Investors should see Japan as univestable, because there really isn’t any acceptance of anything remotely close to capitalism there. You’ll never get equity-like returns in Japan because most Japanese companies are bank accounts. Just start picking stocks and looking at them. Nintendo is a great example. It’s a cashbox that just happens to own the Seattle Mariners and make video games. No big company like that would ever get away with that kind of capital allocation in the United States. The Japanese have a cultural disdain for taking care of shareholders.

        My focus was on the packaging, not the asset or even broad indexes. Suppose someone starts a 100% equity financed company investing in P2P loans and lists it on the market. People will think about it differently because it’s a “stock,” even though there isn’t a fundamental difference between that stock and having your own P2P portfolio. The stock will be much more volatile than a similar portfolio of p2p loans in your Prosper.com account.

        What I’m saying is very different from the premise of the Dow 36,000 book. Given equal fundamental exposure, people see stocks differently than they do other assets. The prices for REITs, for example, are way more volatile than the prices of the underlying real estate. Exposure is the same; relative values at any given point are not. Hence, the volatility in between is the primary risk.

        • JayCeezy says

          Not sure what you are talking about with Japan and democracy. After WWII, they adopted a western constitution, and everybody gets to vote over the age of 20. They elect representatives who work with the PM, just like Congress and the POTUS. Sounds like democracy to me.

          Nintendo is a great NASDAQ component, not in the NIKKEI 225. They are making a product that is too expensive, and lacks quality. People don’t buy that product in any culture. The company’s value has been poleaxed , as you can see in this article here.

          Seems like you may be confused by why Nintendo is sitting on cash. My thought is, like many American companies that have survived this last vicious 5-year (and counting) downturn, there is no place to put it. Capital Improvements are not a good return on investment. Hiring, marketing, software, design, all are places where costs are to be cut. There is no good place for that money at the moment, and they are sitting tight until circumstances change. It may take patience. If you have another idea why a publicly traded international company answerable to a Board of Directors and stockholders that include massive public and private institutions including investment banks, I would like to hear it. REITS are required to pay out profits as dividends, so the underlying value of the real holdings are just part of the equation; in an environment like the U.S. has had for the past 30 years where real interest rates have declined, the profitability for those REITS is impacted favorably. In a few years when interest rates rise, you will see the other side of that razor blade.:-)

          Did you get my point that it is not just the NIKKEI, but the European FTSE and U.S. NASDAQ that have been walloped and are still far below their highs? This is not about an “extreme example”, or “volatility”. It is about bubbles, value, and forward-looking earnings. “Packaging” is what caused derivative and subprime losses; 100 widgets of questionable value bundled together does not ‘spread risk’. Stock splits do not add value. You may see a reaction from some buyers who have forgotten the Internet bubble in 2000 (when the NASDAQ was approaching 5,000, and 13 years later is at 60% of that nominal value not adjusted for inflation). But these stock splits are happening in the past few years when the markets have been rising anyway. If stock splits were to truly add value, then why don’t the stock shares split every week?

          Anyway, volatility as the primary risk factor is not something I can see or quantify. I wish you well, JT, in your adventure to financial prosperity! Please have the last word if you so desire. See you on the blogs!

  23. says

    With the sequester in affect, I wonder what the markets will do this coming week. Will things be as dire as Obama says things will be when he was pitching to get an agreement done? Hmm.

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