How Much Risk Can You Handle?

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Two days ago in “A Hopeless Reader,” I talked about the importance of knowing your risk tolerance. Reader Mel had this to say about it:

I’m worried too, but going from fully to zero to 75% invested in a matter of days? If I don’t know which way the market is going, I try to pick a percentage–50, 30, etc–that I can live with for at least a couple of weeks while waiting to see if there’s a direction forming. That way I’m not pretending to know something I don’t know, and I’m protected either way.

It appears to be a common problem trying to find an entry point to deploy a certain percentage of assets after the markets have rallied, and you have sold out prematurely.

Here’s an easy way to determine your risk tolerance. Say, you have a total portfolio of $100k in cash and want to re-invest in the market. How aggressive should you be? Should you go in 100% this late in the game or use a smaller percentage?

Let’s find out where you are coming from in these 3 scenarios:

1. Imagine that you have invested your entire $100k all at once and, right thereafter, the markets head south and your sell stops are triggered leaving you with a 7% loss, which equals $7,000. How do you feel about that? Are you aggressive enough to accept that situation without being emotionally upset? If not, move on to number 2.

2. Assume that you only invested $66k (2/3 of your portfolio value) and the same circumstance as above occurs. The markets reverse their trend right after your purchase, and you lose 7% again. Since you only had $66k invested, your actual dollar loss would be some $4,600, which represents 4.6% of your total portfolio. Do you find this risk more acceptable? If not, move on to door number 3.

3. Same situation as above, except your initial investment is only $33k (or 1/3 of total value) before the markets head south again. Using the same 7% sell stop, your loss would be $2,300 or 2.3% of your total assets. Is that more in line with your risk tolerance?

If not, you should not be in the markets to begin with. This is a simple but quick and effective way to evaluate your risk profile. Sure, you can get far more complicated, but what it comes down to is how much can you accept to lose while in pursuit of growing your portfolio?

Next time, you are faced with an investment decision, apply these simple rules (and involve your better half if necessary), and you will find that your decision becomes much easier.

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Comments 6

  1. Ulli,

    I like the message today about risk tolerance. I believe at least talking over my investment intentions with my spouse is a good idea. I do that because she sees things a little differently than I do at times and that can be a good thing and possibly keep me from making a mistake. To me the most important thing is not to take too big of a risk by thinking I am smarter than I really am. One thing I avoid are leveraged invest vehicles such as 2 beta ETFs and the standard 2 beta index mutual funds and sector ETFs except for Gold ETF symbol GLD of course.

  3. Ulli,

    Thanks for publishing my comment and for your helpful analysis of the three levels of risk. Actually, I would pick one of them based on a combination of my risk tolerance and some seat-of-the-pants estimate of how likely the market is to go up. I know this is less scientific, but in fact my risk tolerance is greater when the market has an established direction (and when people like you whom I trust are advising being mostly or fully invested) than when it is choppy and unpredictable, which would move me toward zero. It's a judgment call, but not an all-or-none one.

    Thanks for your generous advice as always,

    Mel

  4. Ulli,

    Sorry for a potentially dumb question, but do you know if trailing stops are commonly provided by the big names? I cannot seem to find it with Vanguard, but it seems to be there for Fidelity. Should I do my best with an excel sheet if I do not have the option available at one?

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