Risk Tolerance Live Fire Testing

Jan 22, 2018
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I had a conversation with an SMI member recently that I’m confident is relevant for many investors.

He mentioned that he has been using multiple SMI strategies and somewhat recently added Sector Rotation. However, a three-day drop of 5.5% drove him out of that position. He was calling to ask whether I thought he should get back in.

I told him I think he’s already answered his own question. In holding a volatile fund, if a downturn compels you to sell, that speaks volumes about whether such a fund is a good fit.

There’s no shame in coming to the realization that certain investments are just too risky for you. In fact, it’s a sign of maturity to know yourself well enough to be able to say how much risk is too much.

In similar fashion, I have several friends who have done very well investing in rental real estate. Over the years, my wife and I have considered making such an investment, but I don’t think I have the temperament for it. I tend to worry too much about the house we live in. I’m not the handiest guy on the block, so when I see or hear a problem, I tend to assume it’ll cost all of our savings to fix it.

These are challenges all investors face — figuring out which types of risk we can handle and how much. Risk tolerance questionnaires can help. However, they are usually completed during times of market calm. So, how we think we would respond to a downturn may be very different from how we’ll actually respond.

There’s nothing like a little live fire testing, such as having real money invested during times of market stress, to reveal your true risk tolerance.

Especially now, when we’re in the midst of an extraordinarily long period of low stock market volatility, it’s easy to get complacent with risk — to think you can handle more than you really can. You can even start to think you’ve been playing it too safe and start tilting your portfolio toward riskier investments.

What should you do instead? You’ve heard it from us before, but it bears repeating. First of all, your benchmark should not be “the market.” It should be the reasonable rate of return you’ve built into your investment plan based on your time frame and yes, your risk tolerance.

If it’s been a while since you’ve taken our risk tolerance quiz, it would be a good idea to take it again. (Also, understand that your risk tolerance is not the same thing as your risk capacity.)

Next, make sure you’ve chosen a strategy that’s appropriate for your timeframe and temperament. If you’re planning to retire in five years, there’s no reason for your portfolio to be 80% Fund Upgrading (with a 100% stock allocation) and 20% Sector Rotation. You get no extra points for taking more risk than you need to.

Then write it down. It’s helpful to have a written investment plan — a description of your goals, strategy, and perhaps most importantly, what you will do or not do during a downturn. If you’re married, write this document with your spouse. Then, especially during times of market stress, re-read it.

What live fire lessons have you learned about your risk tolerance?

Written by

Matt Bell

Matt Bell

Matt Bell is Sound Mind Investing's Managing Editor. He is the author of five biblical money management books and the teacher or co-teacher on three video-based small group resources. His latest book, Trusted: Preparing Your Kids for a Lifetime of God-Honoring Money Management, was published by Focus on the Family in 2023. Matt has spoken at churches, universities, and conferences throughout the country and has been quoted in USA TODAY, U.S. News & World Report, and many other media outlets.

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