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Learning Your Risk Tolerance

The secret to successful investing is learning your own style: meaning what works for you. There is no "correct" approach that everyone should learn. However, everyone needs to learn how much risk they can comfortably handle. It is the single most important investment issue for long term success in the market.

What Is Risk?

For most people, risk simply means "losing money."

But many people define risk as "price volatility." This definition takes into account the fact that you may have to "worry your way through" some rough spots, before finally seeing a profit.

Price volatility is measurable, and the "beta" statistic gives a rough indication of how much more volatile a stock is than the overall market. A beta of 1.3 indicates a stock is 30% more volatile than the overall market. When the market rises 10%, a 1.3 beta stock can be expected to rise 13%. But it also falls 30% more than the market as well.

Betas, however, don't measure a stock's "quantum" price jumps at all. A stock with a beta of 1.0 that reports poor earnings can still lose 50% of its value overnight.

Risk And Reward

It is a common phrase: the "risk/reward ratio." What does it mean?

The risk/reward ratio is simply shorthand for the old adage: "high reward comes with high risk."

Traditionally, the stocks that have returned the most, over the long haul, have had the greatest price fluctuations, along the way.

This simple fact is often ignored, particularly by new investors. It means you must learn to live with price fluctuations, if you seek the highest rewards.

It would be great if every investment always went up, straight up, and never gave up a day's gains.

But if that type of steady advance is what you need to feel comfortable, stocks are not for you. Only bank certificates of deposit (CDs) always increase every day. Even government bonds fluctuate on a day-to-day basis.

When Risk Overwhelms

All too often, we get an email along the following line:

I bought 1,000 shares of XYZ at $42. Now it is at $32. I've lost $10,000 and my spouse wants me to dump it, but I think we should hold on. What should I do?

Unfortunately, we cannot really answer this type of email. Briefing.com is never able to give to personal investment advice.

The primary reason is that we don't know your risk tolerance level.

The only meaningful way to answer such a question starts with "examining your risk tolerance." There is never any crystal ball as to a stock's future price movement. All anyone can do is balance the possibility of higher prices with the risk that higher prices will never happen.

An understanding of the possibilities of future higher prices versus future lower prices has no value by itself, however.

The understanding of future possibilities must then be balanced by how well you can handle the worst possible outcome, both financially and emotionally.

Furthermore, you also need to be able to handle the uncertainty of events along the way towards the reward fulfillment.

Any investment undertaken without a deep understanding of your own individual risk tolerance levels is a foolish investment, by definition.

Risk Level Mismatches Are Common

When someone asks a question like the hypothetical email above, it indicates they have chosen an investment whose risk characteristics were beyond the investor's risk tolerance level. However, in most cases, those risk possibilities were known in advance. The risk side of the equation was ignored and when it happened: the risk mismatch became a problem.

This mismatch of latent risk becoming real and more than your tolerance level is not uncommon. It happens to everyone, including pros.

When it does happen, however, you only have two choices to becoming more comfortable:

• Find a way to live - financially and emotionally - with the newer risk levels.
• Get out of the situation, even if it means a "real" loss.

Hanging on to an investment simply to avoid a loss is the single most common cause of even larger losses.

Historical View on Risk

Before the stock market became a middle class endeavor (in the late eighties), a traditional adage given by stockbrokers was "never put money into the stock market that you can't afford to lose entirely." This adage was meant to prevent people from ever encountering the risk mismatch problem.

But in the nineties, with the advent of 401(k) plans and online brokerages, the mass media began telling people: "you must own stocks; stocks always go up."

They never told people about the risk tolerance issue, however. It is the reason so many people were so hurt in the collapse of the bubble.

One Way To Think About Risk

Many people start investing using the idea our initial investment (the check we wrote to open the brokerage account) is the "real money" and all other unrealized gains or losses are "house money."

It seems straight forward to think this way, but this approach can be the source of great anxieties, unfortunately. It is the root of the idea that "you haven't lost if you haven't sold" - which is a double-edged sword.

To handle risk, you need to come to understand two fundamental facts:

• It is ALWAYS your money.
• You WILL lose, sometimes, because loss is unavoidable.

Unless you embrace these two principles, you will eventually make the following mistakes:

• Holding on to position with an unrealized loss, to avoid taking a "real loss," when you no longer have any premise for the stock.
• Selling at a loss a stock for which you have a reasonable premise not yet disproved, simply because the price has fallen, and your fear has overwhelmed you.
• Buying a position whose risk possibility you never even considered in advance.

If you avoid the concept of "house money," some of this issues can be avoided.

Examples

To demonstrate the problems of "house money" thinking, consider this.

Imagine the following occurs, called situation A:

• You purchase $10,000 worth of XYZ.
• It immediately rises to $14,000 in less than a week on no news at all.

Who can argue with this? You've got $4,000 in profits!

Now imagine scenario B:

• You purchase $10,000 of XYZ.
• It immediately rises to $14,000 on no news.
• Overnight, again on no news, XYZ falls and your position is now worth $10,000, a week after you bought it.

Would the decline from $14,000 to bother you? For most people, it does not. Somehow, the $4,000 "lost" in the fall between $14,000 and $10,000 seems like "house" money.

Now imagine scenario C:

• You purchase $14,000 of XYZ.
• XYZ immediately then falls to $10,000.

Does situation C bother you more than situation B? It bothers most people. They simply cannot let go of the fact that they have "lost" $4,000.

But, in truth, there is no real difference between situation B and situation C.

Whether you buy at $14,000 or $10,000, when the stock is at $14,000, it's YOUR money. You have "lost" $4,000 in either scenario.

But if you can live with scenario B, you can learn to live with scenario C. In fact, if you want to succeed in the stock market, you must learn to do this. If you invest in the best growth stocks, you will eventually encounter both scenarios.

On the other hand, if both scenarios B and C bother you, you should not be buying volatile stocks. Period. You probably think the mistake causing your discomfort is "not selling when it was worth $14,000," but the truth is that the mistake was buying XYZ in the first place.

Taking Real Losses

The above example used situations were no news was involved. The story might be different in Scenario C if the fall in price came because of a poor earnings report or other event that disproved your investment premise.

If that were the case, you should take the real loss and sell, in order to become an "inadvertent" long term holder whose only goal is to "get back even so I can sell this dog." On such investment premises as these, fortunes larger than yours have been lost.

No One Answer For Everyone

Just as there is no right "favorite color" for everyone, there is no "right" risk level for everyone. Only you can determine what level of risk is right for you.

You need to find the right balance between the amount of risk you are willing to take, and the amount of risk you can actually take. All too often investors think they are willing to take risk, but when it happens, they find out they aren't.

Surviving in the market long term is the most important way to make the market work for you. To do that, you need to learn your own risk tolerance ability.

If a real loss helps you to that level of understanding, and you can financially afford the loss, it can be valuable emotional tuition. Frankly, it is tuition that every experienced investor has paid, at one time or another. 

Robert V. Green