Why investors can’t gauge their own risk tolerance

When people start investing money, one of the exercises they engage in is determining their own risk tolerance. Usually, this process is handled by filling out some sort of questionnaire, such as the one below, that has multiple-choice questions:

If you had $10,000 to invest, would you:

• Be willing to chance earning 30 percent growth knowing you could lose 30 percent?
• Be willing to chance earning 10 percent growth knowing you could lose only 5 percent?
• Be willing to lose nothing, knowing you could earn no more than 5 percent?

We often whiz through these quizzes at a blazing pace because, in a simulation exercise, we know exactly who we are. However, there are two types of behaviors that we have within our personality: How we act in a natural state, when we are relaxed and have no pressure, and the adaptive state, when we are under heavy pressure. Unfortunately, these quizzes don’t really put us under any pressure, so they don’t really tell us how we would react when markets are in roller coaster mode.

With the Dow Jones Industrial Average experiencing two 1,000-point drops in recent weeks, and having fielded many, many investors’ calls, I was reminded that investors truly do not know how to measure risk.

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Measuring reward is easy. You can clearly see if your 401(k) plan is up or down 20 percent by just opening up your statement and seeing it on the front page. The number that you don’t see is the risk that it took you to get to that 20 percent mark … until the markets start to turn due south, and that is when you turn to the state of panic.

The Dow Jones didn’t have a single down month in 2016. Not one. The two main emotional drivers in the stock market are greed and fear. So, when the markets are going up month after month without any sign of slowing down, our Cheshire cat grin of greed is secretly getting larger as we see our statements grow every month. It’s funny, because nobody ever calls up and asks, “Ted, how much did we make today?” or “Ted how much are we up this week?”

When the markets are climbing, people just sit back and enjoy what’s happening without hardly any questioning at all.