Although it is not formal research, my experience suggests that people are naturally risk adverse. Risk tolerance starts low and rises over time with experience, education, cultural norms and success. It also cycles up or down with specific circumstances, the economic climate, or a wider variety of other factors. In general, people prefer less risk over more risk in investing.
This creates a very real dilemma. Risk free investments aren’t adequate to meet most people’s financial goals. Simply put, most people don’t earn enough to accumulate sufficient amounts for their retirement needs. In today’s world, retirement years can easily last as long as working years.
For most people, setting money aside each month is insufficient. Funding a reasonable retirement requires riskier assets, compounding over several decades. Nearly everyone’s preference would be less risky investments (risk intolerance). Everyone’s need is for more risky investments (risk tolerance). (For more, see: What Is Your Risk Tolerance?)
Understanding the Impotance of Risk Tolerance
The notion of risk tolerance is that each person has a different ability to withstand portfolio fluctuations. Based on that personal ability, the perfect portfolio would be one that maximizes performance without exceeding the fluctuation limit. And, also based on that ability, there’s no point in pursuing a more aggressive portfolio posture.
I get all that, but I’m uneasy with the implications. One major implication is that millions of people are destined to fail financially (as measured by their ability to fund a decent retirement) because they can’t withstand portfolio fluctuations. It’s like a built in excuse to fail.
How would we respond to these similar statements? “Well, I’d rather not get polio, but I hate big needles and I can’t tolerate inoculations.” “Sure, I understand the principle behind insurance, but I can’t afford to insure my car.” “I’d like to quit smoking, but I just can’t stop.” “I know I shouldn’t be on the phone during church, but what if I miss a call?” Seriously.
How are any of those different than, “When I retire, I’d like to have some extra money set aside, but I just can’t stand any risk. I keep all my money in the bank.” It is mostly the same argument, but money makes it a very different measure. And this is the powerfully important point: what is the personal and family cost for tolerating that apprehension? Simply, it means failure to achieve what you’d like for retirement. (For more, see: Do You Understand Investment Risk?)
How to Become More Risk Tolerant
If any of this sounds like you, what needs to be done to overcome that anxiety? Are there steps you can take to become more risk tolerant? Here are a few suggestions from me:
- Learn more. Most studies on this subject suggest that risk tolerance rises as people learn more about investing. Find a good book or some articles on investment basics. Investing isn’t hard, but understanding four to five solid principles is enough to help.
- Start small. Similarly, people tend to become more risk tolerance with investment experience. Stock market cycles can be scary at first, but they become easier after you’ve survived one or two. If you start with smaller amounts, the first cycles won’t seem so bad, either.
- Create separate wallets. Set up accounts for different purposes. Money being saved for a new car shouldn’t be mixed with money for the kids’ college. A retirement account should be separate, too. This can help because the longer-term money (retirement accounts) feels less urgent than the car money, allowing you a bit more comfort and tolerance.
- Ignore CNBC. Any of the television news or other outlets benefit from drama. This is entertainment first, and education second. Every story feels important because anxiety is a key part of drama (horror movies, anyone?). If you are already nervous, this is a recipe for failure.
Investing isn’t rocket science and almost anyone can learn enough to succeed. But our natural risk intolerance is a huge impediment. Anyone wanting to achieve long-term financial goals needs to fight back. Don’t let risk intolerance conquer your ambition. (For more from this author, see: How to Create a Low-Risk, High-Return Portfolio.)