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Keeping Up with the Joneses: Risk Tolerance

October 21st, 2013 by 
CameronDaniels

The idea of lifestyle creep is the slow build-up of "necessary" expenses as your income increases. I myself have experienced a bit of it in my career, noticing small purchases that I used to consider luxuries as being more commonplace. What I want to touch on in this article, however, is something I think is unique to the blogosphere or personal finance fanatics: 'risk competition', a derivative of risk tolerance.

As part group of people who value our net worth, time and personal finance well-being there is a fair amount of healthy competition on net worth, savings rates and age of financial independence when you're seeking new personal finance knowledge. Perhaps this competition may lead individuals to make riskier financial decisions that they are truly comfortable with.

What is your true level of risk tolerance?

Many of the other forms of competition that the personal financial blogosphere can inspire is healthy to an extent. When bloggers participate in spending holidays or saving binges it may inspire some to up their savings rate or reduce some of their unnecessary expenses.

To a certain extent, this is healthy. Too much of this, however, and I would suggest that the focus is misplaced.

When it comes to investment decisions, however, it becomes a more personal decision. I am not a blogger who dismisses any discussion of asset allocations with"omg! it's a personal decision and i'm not a financial planner so do what you feel". I believe there is a proper asset allocation to target at certain ages and I am not shy in my own appetite for risk. I do, however, recognize that each investor's risk tolerance is different. I do not have kids or am nearing retirement so naturally I have the capacity to take on more risk, but I also have a natural inclination to take on high-risk, high-reward opportunities (and no, I have not been duped by an Ponzi schemes).

Risk Tolerance: Buy now or be priced out forever!

Buy now or be priced out forever!

Where this becomes an issue is when the media or good old fashioned jealousy take place. Regret is a powerful emotional tool and the media loves to exploit other people's gains to inspire envy. When you are a renter and you see home prices jump 12% in a city, you feel a tinge of regret at your lack of housing.

If you are in bonds and see flat returns as stock returns are robust, you see others' returns as a loss of opportunity. This powerful emotional response may lead investors to make sub-optimal decisions given their risk appetite. If I posted my returns this year, it will probably inspire jealousy in some of our readers. That is not to say that I'm an excellent investors, just that I was able to bear a lot of risk which has paid out in recent years due to my high levels of risk tolerance.

If in the next few years there is a major market correction, I will be the first to recognize my jealousy of more conservative asset allocations.

Why does this matter to you?

The media does a fantastic job of highlighting outlying data points. The day trader who made millions. The house flipper who retired at age 28. The entrepreneur who struck it rich. Every story in its own very small way undermines the confidence of those who have different risk appetites.

"Look at all these people making millions off the stock market and here I am investing in stupid old bonds!"

Taking an honest appraisal of your own risk tolerance is important to ground what your true allocation should be.

Can you handle your net worth decreasing 30-40% in a single year? How soon do you actually think you need the money you are investing? Are you dependent on the income from investing on a day-to-day basis? Can you handle a stock market drop?

These questions will help inform how you should really feel about those who speculate and make it rich in markets. It doesn't make my reaction any less emotional, but at least I feel I am detached enough to make a rational decision after recognizing my own emotional response. I can only hope that as a writer, my own opinions on risk appetite and investing can inform and provide a reference point for discussion.

I hope that those who have differing risk appetites from my own can see my own opinions and examples for what they are: a reference point and an example. Not a model that every single person in every single situation should follow.

Cheers,

Cameron Daniels

Don't Quit Your Day Job...

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