Can You Stand the Heat?

The single biggest hurdle for the DIY investor is handling emotions. Depending on the volatility of the market and the size of the portfolio, investors translate a portfolio downdraft into losing the equivalent of a new car, a nice vacation, or their kid's college tuition over a short period of time. Second guessing then eats away at the DIYer psyche. This also works on the upside. After a good week or month, you can't help but focus on the fact that, if you cash in recent "winnings," you can take the profits and buy a big screen TV for every room in the house. The next thing you know you're in la la land dreaming of the things you can get. That's until you run head on into the next 4 x 4.

The away around all the angst ( at least according to those who have opined on the sub market performance of individual investors) is to get a plan and pretty much stick with it through thick and thin. This requires careful thought on how to allocate assets (what percentage to invest in each asset class) among the major asset classes. A truism of the investment world is that this decision is a primary determinant of long-run performance. In previous posts, I have examined questionnaires and quizzes to provide some guidance in arriving at appropriate percentages. I have urged readers to consider how they have reacted in past volatile markets - of which we have had plenty since the start of the decade. How did you feel when the S&P 500 reached an all time low in 2007? How about in March of 2009 when it hit the bottom after free falling for 15 months? Did you hold in, capitulate, or see it as a buying opportunity of a lifetime?

Analyze your feelings and behavior during volatile markets, and it gives you excellent feedback on your capability for taking risk. Also, take into account that, when you answer risk tolerance questionnaires, you are somewhat biased. Answer the same questionnaire in late 2007 when the S&P 500 has had a good upside run and then again in March 2009 when there was "blood in the streets" and you'll come up with different assessments. You'll score higher as a risk taker after a positive market environment.

The bottom line is that personal risk tolerance isn't a fixed immutable number, as is sometimes projected. The more times we venture out of the cave without running into a woolly mammoth, the more of a risk taker we become and vice versa.


An excellent discussion of the influence of recent markets on perceived risk tolerance is covered nicely by Jason Zweig in "Your Money & Your Brain" - a must read for every DIYer.