What’s Your Pain Threshold?
Everyone is different, and it keeps the world interesting and it keeps me on my toes with my clients. One of the most crucial exercises we do with everyone we work with is to go through their risk tolerance assessment and then review it every year. Anything can happen in a year, and people’s circumstances change. Right, isn’t the only constant in this world is change? Well whenever someone’s situation gets adjusted or they get closer to their financial goals, they tend to switch their objectives for their investments as well as their risk tolerances.
An account objective can be growth oriented, income driven, capital preservation, or anything in between. Think of the growth objective on the more aggressive side of the spectrum and capital preservation on the conservative side. So where do you match up? Hah, that is a loaded question and most people don’t even know what their true objective is or if their accounts are even invested according to their objectives. Now before we dive into how to accomplish this proper alignment, let’s go through your risk tolerance because they go hand in hand.
Your risk tolerance or pain threshold as I like to call it shows how much risk you are willing to take for more POTENTIAL return. No returns are guaranteed, so potential is as bold as I can make it. Most people initially say, sure let’s take on a lot of risk because I want my money to grow and grow fast. But can you guess what happens? Well the stock market has one of their 10% pullbacks, and all of a sudden that growth minded, risk taker stops dead in their tracks. Wait a second, I wanted growth, not for my account to go down by 10%. Well I would like to know where you can get 20% gains without it ever going down, and please let me know if you know this secret. So this is where the account objective and risk tolerance cross paths.
You see when you want growth, have growth oriented investments, but then the market goes down, sometimes, you freak out and want to change gears. When I say change gears, I mean you go from an aggressive allocation to a very conservative one. So now your account’s investments don’t match up with your actual long term objective because your silly old risk tolerance got in the way. You thought you were high risk, high reward type of person, but now it seems you are a low risk; give me whatever returns I can get type of person. And this is exactly why we need to re-evaluate your investment objective and risk tolerance every year. It works the same when you have a low risk tolerance, conservative account objective, and the market goes sky high. And you ask why my account isn’t up as much as the stock market is?
Since we don’t live in a perfect world, and we are always changing and adjusting our lives, it is critical to do 2 things with your investments.
Think of it this way, you really want a house on the beach. A house right on the beach with gorgeous ocean views from every room. You know there have been storms before that have brought water into the house, damaged parts of the house, yet it is still your dream. So you start looking at real estate and find the perfect one. And it happens to be in your budget, YAY!! Knowing the risks associated with owning a house on the beach, (Super Storm Sandy), you put in an offer, and it gets accepted. Your first summer is amazing, you have all your family and friends down, and create loads of memories. There are a few setbacks along the way, such as buying all new furniture and all the entertaining means more money, so it is an expensive first summer. To you it is still worth the extra money, time, and energy keeping up a beach house. Then in the winter, a huge storm hits. Your full time home is about 2 hours away from the beach house, so you don’t make it there immediately to see the damage. By the time you get to your dream house, there is water throughout the downstairs. Uh oh, this can’t be happening! Well it has, and you knew the risk when you bought it. So do you start repairing what needs to be done, so it will be ready by the summer or do you sell it at a loss? Do you remember why you bought it in the first place and what your long term goals are? Now you might say that is what insurance is for, and to that I will say, there is insurance type products for your investments too. But that is for another posting.
Think of the stock market in the same way. You become invested and it just so happens to go up a few weeks in a row, then a few months, and you are living the life. Your goals are that much closer! Then there are some setbacks, such as Britain leaving the EU, the FED raising interest rates, and another one of President Trump’s tweets that send the markets downward. Nothing major, you are in it for the long haul, right? And finally there is a bigger pullback that leaves you scratching your head. You knew the market goes down from time to time, and actually averages a 5-10% pullback each year. Yet it still hurts with your money. So do you sell the beach house or your stocks? Or do you remember your long term goals and stay put?
I can’t answer this for you, but hopefully it puts it in perspective for you a little bit for our next stock market pullback. It is my job to guide you along the way, and try (I said try) to put your emotions on the sidelines during your decision making process. I know it can be very hard, but making a decision while we are emotional tends to lead to rash decisions. And I will leave you with a tip to review your objectives, risk tolerance, and time horizon before you invest and throughout your investing future.
Quick 30 Day Spending Cleanse Update: Month 3 is no manicures or pedicures. While I normally dread getting my nails done since I always mess them up, I did have some weak moments and really wanted a pedicure. I persevered and went without so I can save an extra $180. A bonus is how good I got at doing my own nails. Next month is no eating out, I better tell my husband this. He won’t be happy!
Jessica Weaver, CFP®, CDFA™, CFS®
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