Why investors can't gauge their own risk tolerance

  • Quizzes that purport to test risk tolerance are often ineffective, since they don't really put investors under actual stress.
  • Fear is a greater motivator than greed. In good times, few check in on how investments are doing. In bad, they swamp advisors with panicked calls.
  • For happy investing, develop a real understanding of how you want to invest your money with both risk and reward.
Olivier Le Moal | iStock | Getty Images

When people start investing money, one of the exercises they engage in is determining their own risk tolerance. Usually, this process is handled by filling out some sort of questionnaire, such as the one below, that has multiple-choice questions:

If you had $10,000 to invest, would you:

• Be willing to chance earning 30 percent growth knowing you could lose 30 percent?
• Be willing to chance earning 10 percent growth knowing you could lose only 5 percent?
• Be willing to lose nothing, knowing you could earn no more than 5 percent?

We often whiz through these quizzes at a blazing pace because, in a simulation exercise, we know exactly who we are. However, there are two types of behaviors that we have within our personality: How we act in a natural state, when we are relaxed and have no pressure, and the adaptive state, when we are under heavy pressure. Unfortunately, these quizzes don't really put us under any pressure, so they don't really tell us how we would react when markets are in roller coaster mode.

With the Dow Jones Industrial Average experiencing two 1,000-point drops in recent weeks, and having fielded many, many investors' calls, I was reminded that investors truly do not know how to measure risk.

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Measuring reward is easy. You can clearly see if your 401(k) plan is up or down 20 percent by just opening up your statement and seeing it on the front page. The number that you don't see is the risk that it took you to get to that 20 percent mark ... until the markets start to turn due south, and that is when you turn to the state of panic.

The Dow Jones didn't have a single down month in 2016. Not one. The two main emotional drivers in the stock market are greed and fear. So, when the markets are going up month after month without any sign of slowing down, our Cheshire cat grin of greed is secretly getting larger as we see our statements grow every month. It's funny, because nobody ever calls up and asks, "Ted, how much did we make today?" or "Ted how much are we up this week?"

When the markets are climbing, people just sit back and enjoy what's happening without hardly any questioning at all.

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This is why there is no doubt that fear is a much stronger emotion than greed. The moment that investments start to turn south, everybody wants to know what's going on and whether it will continue, even though the loss may only happen over a few days and not even months or years. Fear is the real driver that can tell you what your real risk tolerance is because, when the roller coaster hits, its first large drop will really reveal whether or not you are ready for the ride.

You may think you know how risky you really are, and you may be able to answer it in a natural state, but how did you really respond over the past week? If you were too nervous to log in online to see how things did or too nervous to even turn on the television, maybe that should tell you a thing or two on how risky you really want to be. Just because you don't shoot for double-digit returns doesn't make you a bad person; it just makes you the investor that you really are when you put your money on the line.

"Get a real understanding of how you want to invest your money with both risk and reward, and you'll be a much happier investor for the long haul."

Happiness is about expectations met or unmet.

If you want to be a happy investor, take a look in the mirror and decide what kind of investor you want to be. Don't take the losses out on your friends, your family or your advisors because you don't know what kind of investor you want to be. Get a real understanding of how you want to invest your money with both risk and reward, and you'll be a much happier investor for the long haul.

— By Ted Jenkin, co-CEO and founder, oXYGen Financial

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