In the last DIY Investor Newbie post, we derived a specific asset allocation . This required a judgment on risk tolerance. Risk tolerance has to do with how well you take the up and downs of the market. Every investment advisor had clients who literally freaked out in the market downturn of 2008/early 2009. Freaking out isn't good because it usually means people sell out (capitulate) when prices are near their lows and getting ready to move higher.
Risk tolerance is tricky. Many advisors present it as if it is highly scientific. They will give you an elaborate questionnaire consisting of hypothetical questions, derive a number (numbers give a sense of specificity), and show where you end up in relation to others using a normal distribution. This is supposed to reveal whether you are a greater risk taker or not compared to others. Guess what? In 2008, we found out that everyone took too much risk. There has been a wholesale shifting of risk exposure since surely too much) as investors have moved into bonds.
Anyways, risk tolerance questionnaire results aren't as scientific, in my opinion, as they are made to appear. They do however typically ask some questions worth thinking about. To see this answer the following questionnaire .
In this post I would like to look at the questionnaire's first 5 questions. The remaining questions will be taken up in future posts.
#1 Age...obviously important. Other things equal, you are more tolerant of risk the younger you are. Still, keep in mind that 5 thirty year olds will all have different risk tolerances.
#2 Lose your job...I'm not sure this is worth a whole lot because it is so hypothetical. To be dramatic it is like asking what you would do if a grenade rolled into a foxhole. The truth is we don't know what we would do.
#3 Income...Other things equal the higher your income the more risk you can take.
#4 Financial responsibility...the more responsibility you have the more cautious you want to be.
#5 Job...Really important. If your job is secure. Tenured teacher/government etc.for example then you can take the greater risk of investing in volatile assets. Some analysts look at a secure job with a predictable pay like a bond. You have a steady stream of income. On the other hand if you are a real estate agent and your compensation is up and down with the real estate market you are similar to a stock.
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