Subscribe to this BlogHow much money are you putting at risk?
If you're trying to figure out how much risk you can stomach in your investment portfolio, there's a key question you have to answer first: What exactly is your investment portfolio, anyway?
Well, now let's move on to another hypothetical average investor: a woman with a $100,000 401(k) plus a $25,000 emergency fund in her local bank. Assuming she, too, can tolerate no more than 56% of her total investment portfolio in stocks, what's the most stock should she have in her 401(k) to keep herself from panicking when things go bad? Should it be $56,000 — that is, 56% of the $100,000 retirement account? Or should it be $70,000 — 56% of the $125,000 in her 401(k) and bank account?
What's the answer? After talking it over with FinaMetrica co-founder Geoff Davey, we learned…it depends. Some people — myself included — don't think of an emergency fund as an investment. They think of it as something else, like a metaphorical fire extinguisher you keep in the corner of your kitchen and hope you never have to touch. To others, money is money, and whether it's in a bank account or a retirement savings account, it's all an investment. These personal decisions are what behavioral economists call mental accounting — the way you sort your money into different imaginary buckets. And how you yourself sort your money determines how you might use FinaMetrica's guidelines: Davey advises applying them to whatever you understand your investments to be.
Another interesting thing that didn't make it into the story: Commentary from Greg Davies, head of behavioral finance for the wealth management division of the financial services firm Barclays. For some of his thoughts about risk tolerance and how to measure it, I recommend his articles, posted online, "How not to measure risk tolerance" and "The Behavioral Science of Risk."
If you'd like more insight into your own tolerance for investment risk, you can take FinaMetrica's test online. Normally, it costs $30 for individuals, but the company is making it available to MONEY and CNNMoney.com readers for free through November 30. If you do take the test, I'd be curious to know your reaction to it. Come back to the More Money blog and let us know what you think.
Perhaps the apt question right now should be "If the entire monetary system can be leveraged ("risked") by institutions too big to fail, how can anyone ever be comfortable again?
I'm a risk manager at a Turkish manufacturer. Since I manage company money I though It would be a good idea if I try FinaMetrica's test. It seems I can tolerate risk more than 93% of an average person. My own estimate though was around 54%. It was a shock to learn that. I found this test very helpful, results deserve some thinking on them.
The concept of risk tests is an interesting one and FinaMetrica looks pretty good, but it misses key changes.
First, the economy and equity markets are much less stable than they were just 10 years ago. We've had two >50% crashes in just the past decade. In addition, asset classes have become more highly correlated: all classes and all countries tend to crash together as all investors try to run through the exits, leaving very few buyers, causing asset bid prices to plunge.
Second, due to deregulation and lax regulation, the incidence of fraud has risen dramatically. We've seen securities that weren't really securities (Stanford, Madoff, Israel, etc.) and bonds that aren't really bonds (Goldman, Merrill, Lehman, etc.). This is not just a US problem: Australia had Rams, Iceland had Glitnir and the whole country went bust, etc. The scheme industry is alive and well; we couldn't possibly hire enough investigators to catch all of them. But, we can punish those we catch quite a bit more severely in the future as lessons to the rest.
Taking risk questionaires won't fix the two big problems above. So, it's back to basics: new investors should start by building up a cash emergency reserve, then investing in bonds to provide stable growth (treasuries, such as GNMAs and TIPS, not Lehman bonds), and finally investing risk capital in equities (registered securities and mutual funds only, not Madoff-type schemes). Established investors should take a look at their portfolios from this viewpoint, too.
Knowing yourself is nice, and the risk tests help this process, but knowing the risks of the investments is critical, and the risk tests don't help this.
Maybe we need a risk questionaire to test each possible investment instead of each investor ?
Is there a promotional code or specific URL required to take advantage of the free FinaMetrica offer?
None is necessary. Just go to the website http://www.riskprofiling.com/money/ and follow the instructions. — Editor
Any risk tolerance questionnaire is really judging a person's "willingness" to take risk.
While this is certainly necessary, it does leave behind the person's "ability" to take risk (judged by a financial planning analysis) and their "need" to take risk (i.e. required rate of return to achieve a financial planning goal).
Only by measuring all three of these risk tolerance dimensions and then determining if they align, can we really see how an investor will react and handle market turbulence. This is the only way I have found to handle the issue with clients or with my own investing.
It was commented that markets are much less stable now than 10 years ago. This is not totally accurate. We were in a bubble 10 years ago, not a stable situation. This caused severe complacency. Equities were more than 150% over valued by the end of 1999.
If investors were not calculating required rates of return based on their “need” to take risk, they were probably letting it roll, based on the fantasy of "it's different this time".
Annual rebalancing to their target asset allocation and continuing to dollar cost average would have helped enormously, even with two bear markets.
I think the level of fear and skepticism in the market now is much healthier than it was last year (total panic) or 10 years ago (total euphoria).
Emotion is not a good thing in investing.