Understanding your tolerance for investing risk will save you many sleepless nights.

What's Your Tolerance Level?

by John Brummitt

Mark Twain once said, “The art of prophecy is very difficult, especially with respect to the future.”

No one can see into the future, so in January 2009, when the stock market experienced its greatest downturn in decades, we saw a mass exodus by investors. When people reached their maximum loss tolerance, they sold their investments and ran scared.

Of course, the market later rallied by 50 percent, after hitting bottom in March. So why did so many people run from the dip in the market? They wanted to reap large returns and suffer zero losses. This is rarely a realistic goal. For a better return on our investments, we need to understand our risk tolerance. In other words, “How much heat can we stand before we get out of the kitchen?”

1. You are more conservative than you think.

The most common portfolio investment allocation for people under the age of 55 includes 70% or more in stocks with the remainder invested in bonds. This puts most investors somewhere between moderately risk-tolerant and heavily risk-tolerant, meaning you can tolerate large losses in order to receive large gains. Putting your funds into a heavily concentrated stock portfolio gives you a higher risk of loss, but also a higher rate of return on your investment dollar.

Why does this make sense? In the long run, stocks outperform bonds almost two to one. (From 1926-2008: 100 percent stock portfolio = 9.62 percent return based on U.S. Large Cap Index; from 1926-2008: 100 percent bond portfolio = 5.43 percent return based on the Intermediate Term Government Bond Index).

However, a recent study by FinaMetrica, an Australian company that produces investment risk surveys, found that only seven percent of investors can tolerate the risk produced by a 70% or higher investment in stocks. When things are going good, the economy is up, stocks enjoy positive returns on their investment, and investors think they can’t lose. As a result, risk-tolerance skyrockets. But when stocks fall like a rock, investors become cautious.

2. Risk aversion sets limits not targets.

It is important to determine the amount of risk you can tolerate. Don’t make the mistake of taking a risk assessment survey and setting your stock to bond ratio in the section it says you can tolerate. Rather, look at the results as a ceiling not to be exceeded; then determine your breaking point (the point where you sell everything and bury it in the back yard). Setting limits on your risk aversion will be very helpful when the stock market experiences a downturn. If your risk survey says you can handle a 70 to 30% portfolio, use common sense to determine if that ratio is right for you.

3. Being comfortable with the risk of your portfolio doesn’t necessarily help you reach your investment goals.

Investing in a conservative investment option, like the ProBlend fund the Board of Retirement instituted in October 2009, would make you comfortable with the amount of risk to which you would be subject. Of course, with lower risk come lower returns, and your goals for retirement will be harder to reach.

Consider three easy-yet-hard fixes for conservative investing: (1) Boost your savings rate, (2) cut back on your goals, and (3) do a little of both. On the flip side, being risk-tolerant can put you farther away from your goals in much the same fashion. Tolerant investors often overestimate the pay off on highly risky investments, and they suffer losses they cannot recoup. Throwing large chunks of savings into the stock market “is a sign of their willingness to do something, not necessarily a sign they know what they are doing” (David Cordell, professor of finance at the University of Texas at Dallas).

Understanding your tolerance for risk will save you a lot of sleepless nights. It will also keep you from drawing funds out of your investments when they hit lows and then repurchasing those investments at a higher cost, making you lose twice. Your financial advisor will never know you as well as you know yourself. Only you can determine how much loss you can handle to gain the rewards you seek.

About the Writer: John Brummitt is business manager for the Free Will Baptist Board of Retirement. A 2004 graduate of Free Will Baptist Bible College, John began working for the Board of Retirement in the spring of 2006.