Why Knowing Your Risk Tolerance Is Important
Back in January, I wrote I finally reached millionaire status or as I put it back then “a two comma club member. A seven-figure Jigga. A paper millionaire.” Before I even completed my celebratory dab, COVID-19 roared up and smacked me in the face. In roughly two months, the S&P 500 dropped by 30%. If I had my entire retirement fund in the market, I would have seen over $300,000 evaporate in 60 days—the equivalent of crashing a Lamborghini or burning down an average home in the US.
That massive drop in the market could have murdered my Early Retirement plans. But that didn’t happen. Why?
- 1All my money is not in the stock market. To reduce risk, I am 1/3 diversified into Real Estate.
- 2I kept my monthly expenses low by living abroad, where my Cost of Living is 50% less than the US.
- 3I didn’t sell a single share. You only lose money if you sell.
How Much Risk Is Too Much
That last one is the most important reason. I didn’t panic and sell. I’m not going to lie; my stomach did a little twist when I saw the market plummet. But, I know my level of risk tolerance. I can tolerate market drops and uncertainty. The flipside to understanding I can tolerate moderately-high risk is knowing where to stop. There is a point where I have to say, “No, that is too much risk for me.”
I have one year of living expenses in cash on the sidelines. I had the opportunity to invest my emergency cash during the market dip with the hopes of a significant gain when the market recovered. But risking my emergency savings would stress me out. That is a level of risk I am willing to live with.
Instead, I stayed the course. I had my financial plan, and it is built for the long term. My emergency cash is meant for emergencies only. Dips in the market and short term craziness, no matter how dramatic, shouldn’t sway me.
As of today (August 6th), my stock portfolio is 2% higher than it was before the crash. Did I miss out on making more money if I invested my emergency cash? Yes. Was it the right thing to do? Yes. If you know your Risk Tolerance, you know when enough is enough.
Examples of Different Risk Tolerance
I have a moderately high personal risk tolerance. Personal finance is exactly that, personal. We each have our personality that affects how we save, spend, and invest. A comparison of risk tolerance is my girlfriend. She is the opposite of a risk taker, with no investments, and has all her cash in a bank account. She went into January with $100,000 and came out with $100,000, a 0% change. Her conservative risk tolerance is a stark difference to my Bitcoin investing friends (the definition of risk takers). They saw their portfolio soar 50% since the lows in March.
Let’s look how $100,000 invested according to personal risk tolerance would have fared over during the last eight months
Girlfriend holds Cash = Conservative Risk
Marco holds Stocks and Real Estate = Moderate Risk
Crazy Friends holds Cryptocurrency and Bitcoin = High Risk
The higher risk investment had the lowest lows and the highest highs. In general, the investments with the potential for the highest returns also have the highest risk. The further left you move to the left, the closer you get to hiding your cash under your mattress. The further you move to the right of the spectrum, the closer you get to buying a lottery ticket and gambling. Only you can decide your personal level of risk tolerance.
To help determine your level of risk, take our Risk Tolerance quiz
Every Financial Move Involves Risk
Taking a financial risk makes some people nervous. It should. Pretty much every financial move you make involves some level of risk. My girlfriend invests in cash. You might think that cash has no risk, but you would be wrong. Cash carries an inflationary risk. Prices of everything goes up over time. Her savings of $1000 may be worth less than $750 in 10 years because of inflation. We’ll get into inflation in a future article, but the point is there is no such thing as a “risk-free investment.”
"Still, it’s important to note that any investment involves some level of risk. The key is to arm yourself with knowledge to help you make informed decisions."
Which one of these four Risk Types do you most closely resemble?
31% of investors are Risk Avoiders. This is the far left of the risk spectrum, where my girlfriend sits. Risk Avoiders are the most cautious. Nearly half (42%) of this group openly state they will not take risks with their finances. Risk avoiders are usually the ones with less knowledge about investments and are unwilling to study ways to mitigate risk. Risk Avoiders are mostly Boomers and female (61%).
The easiest group to be in. You literally don’t have to do anything. Avoiding risk doesn’t require research or effort. If you avoid risk, you also avoid the emotional roller coaster that sometimes comes with investing. Stability is very calming.
This is also the most difficult group to be successful in. Successfully building wealth without investing is like paddling out on a surfboard, against the waves, with one arm tied behind your back. Saving up for anything: a car, a house, college, retirement will be 1000% harder without investing. Also, as I mentioned earlier, there is no such thing as risk-free. Even holding cash has inflation risk, currency risk, and the risk you may not have enough money to retire on.
Education is vital. First, understand that even holding cash has risk. Start with these three topics: Inflation, Compound Interest, and the Time Value of Money.
Most investors (42%) fall into this category. Risk Mitigators are careful about risk but less so than Risk Avoiders. Investors in this profile characterize themselves as willing to take risks after significant research (89%), but also associate risk with loss or uncertainty in their investment outlook. However, they remain uncertain about their approach to investing and risk and have a strong preference for low-risk investments. Demographics in this group are evenly split between Millennials, Gen X, Boomers, and gender.
The majority of investors fall into this group, so there are many resources to help educate this market. By investing, this group avoids the inflation risk that Risk Avoiders take on. Risk Mitigators diversify investments and spread out their risk. They take steps to increase their wealth while reducing their downside.
Rapid swings in investments make Risk Mitigators very nervous. If the market becomes volatile, this group tends to sell and move to more conservative investments. Selling when things are down is the worse time to sell.
I get it. Uncertainty makes people anxious. This group will be most helped by having a Financial Planner—someone who can layout a strategy and help them navigate it. If you don’t want a Financial Planner, find a mentor. Anyone you can talk to when markets get inevitably rocky, and you need someone to talk you off the ledge.
25% of investors identify as Risk Managers. Investors here are still cautious, but they are willing to take educated risks after doing research. Nearly half (49%) invest in the stock market and use 401K plans to maximize their retirement savings. While they are more comfortable with risk and understand that risk = opportunity, they spread their investments around and “don’t keep all their eggs in one basket.” Most Risk Managers are male (61%), and again, Millennials, Gen X, and Boomers are equally represented.
This is the best group because I’m in this one . Folks here tend to be doing all the right things. They understand risk but are not fearful of it. Risk Managers view risk as opportunity and look to leverage opportunity, but stop short of being careless. Unlike Risk Embracers, Risk Managers meticulous research investments and look to reduce risk.
Time consuming. This group is unlikely to use a financial planner, preferring a DIY approach, rather than paying a fee. Understanding investment options and planning scenarios and takes research and research takes time. Risk Managers trust in their research, education, and smarts, which can lead to over-confidence.
Don’t start spending your money early as a “reward” for doing well. Stay the course, and avoid lifestyle inflation. Don’t get overconfident. Don’t veer away from your plan because you have “play money.” Buy and hold gets boring. Resist the urge to make things more exciting by looking at riskier investments (STAY AWAY FROM CRYPTO).
A small minority (3%) are a part of this is the far-far right of the risk group. Highly tolerant of risk, this group doesn’t bother researching before investing and views diversification as unnecessary. These are the risk seekers- hunting for the highest potential gain and are willing to accept the highs and lowest that go with the risk. Risk for this small minority of investors is considered “Exciting” (39%) and are willing to make big bets to maximize their gains. These folks are overwhelmingly young (56% Millennials) and male (67%).
Honestly, I’m not going to spend much time on this group, because if you are a Risk Embracer, you aren’t likely to be reading this. Buuut for my other readers, if you are curious about this group, STOP. If you want the adrenaline rush of taking risks, go swim with sharks, take up base jumping, or buy a Ducati.
"Nomadic FIRE is not about “Get Rich Quick” schemes. Get rich slowly and safely. Don’t take risks with your financial future."
Understand that wherever profile you might see yourself in now does not mean it cannot change. Your tolerance will likely change over time. When I was younger, I chased the big returns with the big risks. As I hit my early retirement, I reduced my risks and worked to secure slow and steady growth.
Your risk tolerance will likely change. Maybe this is your first time investing, so you pick conservative investments to dip your toe in the water. Maybe after doing more research and more investing, you feel more comfortable with risk and invest in a 100% stock ETF. Maybe you are only in your 20s and feel comfortable investing aggressively now, but maybe your risk tolerance changes when you have kids and need to save for their college fund.
Understanding your risk tolerance is the first step. Knowing your relationship to risk equips you to make smarter financial decisions.
Are you ready to determine your Risk Tolerance? Start the quiz by clicking the button below.