A reader writes in, asking:
“I graduated this spring and found a job this summer. I enrolled in the 401-k to get the match but didn’t originally spend time considering which funds to use. Now I’m rethinking that decision. Do you know of any websites that will help me figure out my risk tolerance? I think my risk tolerance is low, but everyone says it should be high because I’m young.”
As we’ve discussed before, risk tolerance is made up of an economic/financial component and an emotional/psychological component.
I think your economic risk tolerance can be reasonably assessed with a questionnaire (e.g., how secure is your job? How large is your emergency fund? Do you have any debt? Could you significantly cut your monthly expenses if you had to?).
But I’m very skeptical of most quizzes that try to assess your emotional risk tolerance. Most such quizes ask you to consider how you would react to contrived hypothetical investment scenarios. In my opinion, the only way to really know where your emotional risk tolerance stands is to examine your real-world investing experience:
- How did you actually feel last time the market crashed? Were you panicked? Somewhat worried? Entirely calm?
- And what did you actually do with your portfolio? Were you able to rebalance back into stocks exactly according to plan? Were you unable to rebalance, yet not so scared that you sold your stocks? Or did you sell all your stocks and move to cash?
What If You Have No Experience?
If you’re just getting started investing, you don’t know how high your emotional risk tolerance is. And that’s OK. In fact, it’s unavoidable.
My suggestion for people just getting started is to just pick something. You won’t get it exactly right, but that’s OK. When you’re just getting started, the impact of your savings rate absolutely dwarfs the impact of your asset allocation. You have time and can afford to either a) make a mistake due to bailing out of a too-aggressive allocation or b) miss out on some years of good stock returns due to having a too-conservative allocation.
And, one way or the other, you will learn. The important thing is to not forget what you learn. For example, if you find that you get skittish when the market gets scary, remember that feeling and keep it in mind when the market is doing well and you’re tempted to move your stock allocation upward.
(Important note: As a new investor, despite having little with which to assess your emotional risk tolerance, you have all the applicable information for assessing your economic risk tolerance. So be sure not to use an allocation that’s more aggressive than your economic risk tolerance would allow. For example, don’t put any money into stocks that you can’t afford to have fall by 50% in the near-term future.)
In his recent book The Ages of the Investor, after suggesting that young investors start with a 50/50 stock/bond allocation, William Bernstein wrote the following, which I think nicely sums up what I’m talking about here:
“The young investor’s first encounter with a significant market decline serves mainly to ascertain her true risk tolerance. Her responses to the decline define the policy allocation that takes her to age 45 or 50. Does she panic and sell? Then certainly her long-term policy allocation to stocks should be less than 50%. If she holds fast but does not have the stomach to buy more, then 50% is likely about right. And if she piles in, then I say, ‘God bless.’ Perhaps she can increase her policy allocation to stocks to 60% to 80%. The next few decades should allow her to test, adjust, and repeat the process at least a few more times.”