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Risk Tolerance – Are We Too Emotional?

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The advisors at Wisdom Wealth Strategies take your risk tolerance very seriously, which is why we encourage our clients to complete a risk tolerance questionnaire. While this task might seem like unwanted homework, it helps provide insight into the emotional decision-making of each client.

­­­­­­­­­­­­­­­­­­­­­­­­­­­­­Every investor needs to work with their advisor to determine what types of investment strategies are appropriate given their risk tolerance. Risk tolerance refers to the degree of uncertainty or volatility an investor is willing and able to tolerate. The financial measure of risk tolerance is a function of several factors including time horizon, income, liquidity, and net worth. This is not a matter that is set in stone. Your risk tolerance is likely to change with your age, income, knowledge, marital status, and other important life events, such as buying a home, paying a child’s college costs, or retiring.

Know Your Emotional Risk Tolerance

Less understood is the emotional component of risk tolerance, but it can have far more influence over investment decisions than the financial ability component. Some would argue that emotions are far more powerful than logic and can drive investors to make decisions without consideration of financial ability. The two emotions that can be the most devastating to investors are fear and exuberance, and both can be triggered through a reactionary impulse. These emotions can lead investors to leave the stock market after it has already declined, and can draw investors into a market rally near its peak. In either case, investor risk tolerance is skewed by emotions which often results in investment decisions that do not reflect the long-term investment strategy.

Still, emotions are an important element in risk tolerance when understood. Realizing that emotions are reactionary mechanisms that tend to drive decisions based on short term events, may help investors keep them in check when viewed in the context of a long-term strategy. It would be hard not to lose some sleep when the stock market experiences a temporary decline. You wouldn’t be human if you didn’t. However, realizing that, the only people affected by such a crash are the ones who actually sell their stocks, might help to keep a short-term event, which is positive or negative, in perspective.

More Risk?

A discussion of risk tolerance and emotion should also include an understanding of the terms risk perception and risk composure.  Risk perception identifies how an individual perceives risk and can be based on many factors, including current mood, past experiences, current market conditions, and recent performance of a particular asset class.  For example, it is common for an individual’s tolerance for risk to increase as overall market performance increases.  In turn, as market performance decreases, so does the willingness to take risk.  Risk composure describes how an individual will actually behave when faced with a financial loss.  Reflecting on behaviors exhibited during a previous market downturn can be one of the best predictors of the true tolerance for risk. It is important to have an open discussion with your advisor about your past experiences and reactions to risk.

The advisors at Wisdom Wealth Strategies take pride in understanding your specific situation and personal risk preference, and we work with you to create a tailored plan that matches your goals, time horizon, and risk tolerance.

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