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Increasing your risk tolerance
By JLP | June 19, 2008
This morning, I asked if it’s possible to increase one’s risk tolerance. The responses were very interesting, and I think that most people feel that yes, it’s possible. I agree.
Tim Ferris (of The 4-Hour Work Week fame) reports that Warren Buffett and Charlie Munger said that someone who can’t invest full-time should park their money in an index fund and get on with the rest of their life. The implication is that doing otherwise is too risky. Or, as Munger put it:
The whole secret of successful investing [full-timers] is non-diversification. If you know nothing [you need] diversity.
However, even if you go for index funds, you still need diversity, i.e., asset allocation. A conservative investor might have a tendency to over-invest in bonds, even though the time horizon is long. So what’s a conservative investor to do, besides save more to make up for the lower gains? Here are some ideas:
- Invest with a partner, preferably one who is younger than you and a male. Men tend to have a greater risk tolerance than women. And risk tolerance tends to decline as one gets older. So investing with a younger male partner should expose you to riskier (but not necessarily risky) investments.
- As KC pointed out, educate yourself about investments. Even if you are not a full-time investor, knowledge about the funds you might invest in will help you to more accurately and objectively evaluate the risk involved. So that conservative investor might be able to talk himself into more stocks than bonds, given that over an extended period of time, the risk of losing his money may actually be smaller than the risk of losing ground to inflation, even if investing in stocks feels riskier.
- Consult a professional. In the same way that knowledge can help to accurately and objectively evaluate risk, so can a professional financial advisor. The key, of course, is finding one you trust. And, as Jerry and KC pointed out earlier today, it’s important to maintain an active role in managing your investments.
- Reevaluate your investments at specific intervals only. Growth tends to happen over an extended period of time so the longer you wait to check your balances, the greater the likelihood that they will have gone up, alleviating the fear of loss. However, the interval should not be so long that your asset allocation becomes overly skewed. Most experts recommend checking your asset allocation and rebalancing your portfolio once or twice a year.
- Create a “riskier investment” fund. This point was made by Dave and Early Retirement Extreme. One tried and true way of changing a trait is to practice something that’s beyond your comfort zone. So it makes sense to make some riskier investments to get used to putting your money at greater risk. There is, of course, a difference between “risky” and “riskier.” For a conservative investor, buying an individual stock can be a “riskier” investment, but it’s not necessarily risky. But I think most people would agree that investing in a startup is pretty risky. In this case, I’m simply advocating a small investment that’s beyond your comfort zone in an amount that you can afford to lose. To get the greatest benefit - i.e., to permanently increase your risk tolerance - you’ll have to do this on a regular basis.
- Make “rainy day” plans for when your risk tolerance is tested. Rick Francis suggests making written plans for what to do when something happens - for example, when the market drops 20%. This may not actually increase your risk tolerance, but it will help you from panicking when market events makes you uncomfortable.
Note: I found a very interesting article (pdf) by a University of Michigan researcher that inspired some of the ideas above.
Topics: Miscellaneous |