Has The Recent Market Turmoil Affected Your Risk Tolerance?

It’s often hammered into us that properly determining your risk tolerance is one of the keys to long-term investment success.  I have often argued the same.  However, there’s a gotcha:  how can anyone ever really know their risk tolerance unless it’s put to the test?  Sure, we can sit around and pontificate about what we would do were the market to drop 50%, but I think it’s one of those situations where you never really know how you’ll react until it happens.  Well, that far-flung theoretical has happened:  the market is down by about half from its peak.

Recessions Can Be Good For Young Investors

For older investors with relatively short time-horizons, this isn’t a particularly pleasurable situation.  There’s no way getting around that, but I think for young investors (say 35 or younger) the financial crisis will turn out to be a net gain.

Allow me to explain.  If knowing your risk tolerance is integral to being a good investor, it makes sense that it would be better to learn exactly what that is sooner rather than later and the current crisis offers a way to do that while our portfolios are still relatively small.  If you panicked at losing 50% of your $10,000 401k account, chances are you’d react at least as negatively when your portfolio reaches $100,000 or even $1,000,000.  If that’s the case, you’ve learned a valuable lesson:  whatever your current allocation happens to be is too aggressive for your risk tolerance and should be scaled back.  After all, the negative consequences of making emotional portfolio adjustments are far smaller with a $10,000 portfolio than one many times that size.

But It’s Not All Positive

Unfortunately, there’s a downside to all this risk-tolerance-awareness hoopla, as best articulated by Ron Lieber in this article I found on Yahoo Finance:  many young people are likely to over-compensate  by taking on far too little risk, creating a generation of ultra-risk-adverse investors that could have severe negative consequences for the nation.  Just as excessive risk-taking often ends in tragedy, so too can excessive risk avoidance.  After all, economic growth is an inherently risky business:  who’s going to take the chance to start that business, labor away to invent the next generation computer technology, or invest in that new factory if society discourages taking risk?  While I think this is an extreme example and very unlikely, it’s something we need to guard against.  The trick is to strike the proper balance.

Has Your Risk Tolerance Changed?

I asked a few fellow personal finance bloggers, admittedly a more financially-savvy lot than most, their thoughts on the subject and whether or not their risk tolerances have changed at all.  The results were somewhat surprising and run contrary to what many people would assume them to be:  overwhelmingly, the people I polled are sticking to their guns and maintaining their previous asset allocations and I count myself as part of that group.  Others, however, have used this as an opportunity to increase their allocation towards risky assets like stocks and real estate, reasoning that today’s low prices represent a bargain and will fuel long-term returns for decades to come.  Of all the respondents, not a single one had gotten more conservative with their investments and three had gotten less conservative.  I think this tact will serve them well over the coming decades.

On the flip side, several respondents commented that while they themselves had not become more risk-adverse, many around them (family, friends, acquaintances, etc) had scaled back on their allocation to risky assets considerably.  While I have no empirical evidence to back this up, I think it’s true that the less financially savvy you are, the more likely it is you’ve become more risk-adverse over the last year.

What about you?  Has the recent market turmoil affected your risk tolerance at all?

Special Thanks to those who responded to my little poll:

NCN at No Credit Needed
Four Pillars at Four Pillars and ABCs of Investing
Stephanie at Poorer Than You
Matthew at Fine Tuned Finances
Pinyo at Moolanomy
The guy behind Dividend Growth Investor
Jeremy at Generation X Finance
Tough Money Love at Tough Money Love and Go To Retirement
Blunt Money at Blunt Money
The guy behind Pragmatic Sage Weekly
Ashley at Wide Open Wallet
Plonkee at Plonkee.com
David at Pimp Your Finances