Knowing Your Risk Tolerance and Having a Written Investment Policy Helps
When managing personal finances and investments, people frequently exhibit irrational behavior for different reasons. If you’re one of these folks, be fair to yourself: It doesn’t even take a spate of market zigzags like we saw recently to prod you into questionable decisions.
Everyone makes choices about money nearly every day – how to earn, spend, save, invest, and so on. Sometimes you pick wisely, sometimes harmfully. Some decisions, particularly those regarding when and where to invest whipsaw from wise to harmful and back, depending on when you reached your conclusion and when you took the plunge.
Rational and Irrational Behaviors
Supposedly, if you can learn more about the cause and effect of your money decisions, and what around you contributes to them, you will improve your financial security. Pinpointing behaviors as either rational or irrational in the middle of the storm comes hard, though. The month of September and October this year provided a convenient and timely case study to help explain why.
For the month of September:
The DJIA lost 9.0%;
The S&P 500 lost 9.3%;
NASDAQ lost 10.5%; and
The Russell 2000 lost 9.7%.
If sensitive to market moves, maybe you reacted to September’s declines and sold big – a flight perhaps revealed as irrational, given the market jump in October (DJIA increased 13.95% for the month - which is not to say that October is an inflection point, only time will tell.)
But if you sold on September 30th, you likely showed loss aversion – one of many often-irrational money behaviors. Psychologically, people perceive losses (or declines in value of an investment) as much as 2½ times more impactful than gains of a similar size. Watch your investment drop $1,000 and you feel more than twice as bad as you might feel good about a gain of $1,000.
Know Your Tolerance For Risk
Most people are loss averse and it’s clear why many sell when market prices decline. Is loss aversion irrational? Or sometimes, is it timely clairvoyance?
What-if situations (what if I had sold or what if I had bought) clearly show that sometimes irrational behavior produces good outcomes.
And sometimes well-trained (and often self-proclaimed) experts, applying rational processes to money management, wind up on the wrong side of the intended outcome, especially in the short term. This helps make investing fascinating and, at times, maddening.
Your Investment Strategy
Because investment markets are complex and potentially both irrational and efficient, understand your tolerance for risk. Define what risk actually means in terms of your financial security, and your willpower to handle markets when fear and greed influence decisions.
A written investment policy statement (IPS) can serve as a foundation for your long-term decisions. Your strategy – and your commitment – may also benefit from testing your strategy’s performance hypothetically in past crises.
Since we can’t predict outcomes that depend partially on luck, we plan according to probabilities. For example, rather than focus on the size of your expected returns, know the probability that your investment strategy can support your desired spending rate in retirement or make tuition payments, fund a wedding, cover health-care costs and so on.
Your broader financial plan drives your investment strategy, not the other way around.
Ideally, when your goals link directly to your plan, you have a better foundation for dealing with investment uncertainty and Wall Street’s effect on your emotions and decisions.
