Since 2009, my primary focus has been helping readers create an asset allocation that matches their risk tolerance. A risk-appropriate investor invests based on what they are truly comfortable with. By aligning your investments with your genuine risk tolerance, you can often find yourself feeling more at ease and financially secure. As time passes, your investment allocation becomes more rational as you make adjustments through different economic cycles until you reach a point where you feel confident in any environment. Discovering your true risk tolerance comes from experience and thoughtful financial planning. As your financial circumstances and objectives evolve, so should your asset allocation.
Figuring out your true risk tolerance can take about 10 to 20 years. So, solely relying on advice from someone who has only invested during up or down market trends can be risky. Through my 27 years of investing, I’ve learned that we tend to overestimate our risk tolerance. To make necessary financial adjustments, it’s important to be in tune with your emotions. Staying informed about personal finance by subscribing to newsletters, listening to podcasts, and reading books can be beneficial.
It’s all too easy to forget what you’ve invested in and how much was invested after a year of not checking your portfolio. Avoid the surprise of realizing your asset allocation wasn’t what you thought during volatile market periods like bull or bear markets.
In a bull market, having a risk-appropriate asset allocation means being confident knowing that your investments in growth assets can benefit from a booming economy. Your disciplined approach helps resist the fear of missing out and prevents you from straying into riskier assets beyond your comfort level. Your asset allocation might become riskier during a bull market if your risk tolerance significantly increases due to a sudden windfall or enhanced optimism about your income potential.
During a bear market, having the right asset allocation can provide a sense of calmness since downturns are part of investing. Despite the discomfort of losing money during a bear market, you retain peace of mind knowing your downside risk. With a risk-appropriate asset allocation, you’ll outperform those who take excessive risks during bear markets.
Understanding the downside risks is crucial for seasoned investors. Historically, the S&P 500 has experienced an average drawdown of approximately 35% lasting around 12 to 15 months. Real estate investors also need to grasp the potential risks involved, evident from the 19% decline in median home prices during the global financial crisis.
It may take trial and error to find an asset allocation that suits your risk profile, likely spanning across two economic cycles. An indicator of inappropriate asset allocation is feeling overly emotional during market swings. For instance, increased irritability during market declines suggests an overexposure to stocks while heightened euphoria during market upswings signifies excessive reliance on investments to reach your goals.
Physical and emotional cues can further serve as red flags for an inappropriate asset allocation. Uncharacteristic behaviors like binge eating, weight gain, or excessive drinking during market downturns might suggest an excessively high exposure to stocks. Similarly, heightened optimism leading to exaggerated emotional responses may indicate an overly risky investment stance.
Quantifying risk tolerance is attainable through developing a rational perspective toward investments. An effective tool is the FS SEER formula, evaluating how much time you are willing to spend recovering potential losses in relation to your income. By understanding your risk tolerance, you can determine the ideal asset allocation that aligns with your financial objectives.
In conclusion, finding the right asset allocation is a journey toward making informed financial decisions based on personal risk tolerance and experience. Through continuous learning and adaptation, investors can navigate market fluctuations with greater confidence and resilience.
