It’s time you got to know yourself a little better.
And the time is now, when the stock market has been mostly falling, the talking heads are raising their voices, and your friends who went to school longer than you did are sending emails asking if you’re selling your investments and putting money under the mattress.
Suddenly, they see risk everywhere and feel it acutely. Maybe you do, too. But here’s the problem with listening to them too much: It can make you sick to your stomach with fear. That can lead to hasty financial decisions and stock transactions you may regret.
To combat those feelings, you can conduct a self-evaluation of your risk tolerance. Two companies, FinaMetrica and Riskalyze, have built businesses around these sorts of assessments. While they generally work with financial advisers who put clients through the tests, both have made versions of their tools available to New York Times readers at my request.
FinaMetrica’s 25 questions for investors is at riskprofiling.com/nytfreetest. Riskalyze’s exercise is at www.riskalyze.com/nytpreview. Theirs are not the only ones, either. The new robo-advisers, like Betterment and Wealthfront, have their own risk quizzes, as do a company called FinMason and many traditional brokerage firms.
Try a few of them, or take an hour or so and run through them all. There are few financial tasks more important than acquiring this self-knowledge because too many people don’t know their tolerance well enough and take on too much risk. This can result in getting greedy and buying more investments while stock prices are high and selling when stocks have plunged, thus locking in losses. The result of such moves is too often a portfolio that earns many percentage points less over the years than it may have if you had just left things alone.
But first, what are we talking about when we say risk tolerance anyway? FinaMetrica’s co-founders do a good job of putting it in English in a paper they wrote in 2012. They say they believe that sorting out someone’s risk tolerance is just one of three crucial steps in figuring a person’s overall risk profile.
The first part of the process is determining how much risk is required for you to meet your goals: What annual return will you need on your investments to meet them, given what you think you can save?
This is not always easy to sort out. Most people have a bunch of buckets of money for different goals, or they try to at least. So what are you aiming to do, and by when? Buy a first home in five years? Send a child to college in 15 years? Retire in 30? And which of these things is most important? Unless you make or save so much money that you can meet those goals through guaranteed returns on certificates of deposit, you’ll probably need to take some investment risks.
The second step is figuring out your risk capacity. Can your plan withstand major events you may not expect, like a mentally ill adult child who requires expensive treatment, the death of a spouse or your own disability? If there’s a shortfall somewhere, can you grab money from other sources? This is one area where a good financial adviser can help by making highly educated guesses, using historical data and software, about the odds of extreme market events testing your capacity or destroying it altogether.
Risk tolerance is the third and final step, and it’s all about feelings and personality. Precisely how does taking financial risks turn your stomach — or turn you on? Humans aren’t so great at figuring this out for themselves, and financial advisers may overestimate clients’ intestinal fortitude.
This is where the tests try to help. The founders of FinaMetrica and Riskalyze are somewhat skeptical of one another’s approaches, as you may expect competitors to be. FinaMetrica asks more questions that range wider. Riskalyze focuses on specific investing situations and whether you might consider (or would feel good about) certain risks based on the possibility of various returns. The company also analyzes portfolios and suggests new ones on behalf of its adviser clients (though not in the test made available
GAZETTE COVERAGEEnsure access to everything we do, today and every day, check out our subscribe page at DailyGazette.com/Subscribe
More from The Daily Gazette: