Knowing your tolerance when it comes to investing is an important staple of your financial plan. As long as you are making decisions that involve money you need to know what your tolerance is. Without that knowledge you will find yourself stumbling through investing decisions and potentially overstretching your financial capabilities.
Risk tolerance is complicated even further when conjoined with investing strategies that incorporate leverage, additional debt and risk tailored to supercharge an investment. In either situation though lack of awareness of your tolerance can lead to a false confidence. It might lead you to make financial commitments that may overstretch your already thin funds, a recipe for potential disaster.
We have got you covered though! Today we will review the two primary components to risk; financial and emotional tolerance.
Parameters to Consider
First let’s review a couple a key feature you will need to understand about yourself financial foundation that will play a key to your risk tolerance.
Job Security
How secure is your current position? A tenured professor has more stability than an unskilled laborer in a cyclic commodities industry, like oil & natural gas.
- What’s your seniority relative to the others at your position level?
- Does your industry/company have a history of layoffs?
- Do you have union protection or tenure that makes releasing you difficult?
- How specialized is your knowledge set, can you be easily replaced, or would you need to train your replacement?
- Would you be entitled to severance package or have a permanent contract in place?
Assess how stable your current position is as it will play a vital role in the emotional component of your debt tolerance.
Current Debt Levels
It goes without saying that your current debt levels will impact your risk tolerance. If you have runaway credit card or other high interest debts then your priorities should be elsewhere for now.
- Is the debt secured by a cash flowing asset, like a business or a rental property?
- Are the debts structured with a fixed or variable rate interest?
- Do you foresee taking on any near-term new debts? Housing repairs, new vehicle or medical issues?
- Have you addressed excessive personal spending, or do you need to get budgeting in order?
- Should you be Paying Down that Debt Instead of Investing?
‘Bad’ debt is like an anchor around the neck that drags down your monthly finances. Even high-income earners can struggle monthly if they try Keeping Up with the Joneses and find consumer debt mounting.
Someone with outsized debt, particularly nonproductive debt should be highly critical of their tolerance levels to investments and debt. Cleanup your situation and get spending under control before making any risky maneuvers.
Financial Goals/Retirement Horizon
Timescale is paramount when it comes to your risk tolerance. COVID 19 resulted in a near 37% total loss, followed by a near 80% increase until December 2021 and then 15% pull back a month later.
Over any 5-year period the US stock market has never once ended negative. There’s a lesson here in Not Timing the Market. The market is quite volatile on a year-to-year basis and thus when you will need the funds plays an important role in tolerance.
- Do you plan to fully retire or only partially retire and cut back on your hours?
- How many years before you will need to tap into your investments?
- Will you need these funds to purchase a primary residence?
- Are you trying to FIRE? If so, is this money going towards tax leveraged or after-tax brokerage?
- Where are you currently relative to the 4% Rule?
- Do you expect to have Social Security or another pension to supplement your finances?
Emergency Fund/Easily Accessible Funds
Your emergency fund will be your runway if things turn sour. The more you have set aside here the greater your risk tolerance can be. I am personally a proponent of ~6 months of expenses in a high yield savings account. There are strong arguments in favor of only 3 months or even as high as 1 year, but each family will be unique.
- Amount of accessible funds outside of savings/checking? (HELOC, Brokerage, etc.)
- How many dependents do you have to take care of?
- Any chronic medical issues you need to plan for?
- Will circumstances be changing soon? Birth of new child or child graduating college?
- Are you the sole income source or do you have a partner or spouse earning?
Financial Tolerance
The financial capacity of an individual to handle risk. Numbers don’t lie and that holds doubly true in the world of personal finance. If you have four maxed out credit cards it is probably isn’t the best idea to expose yourself to additional risk.
The good news is that your financial tolerance is typically quite a bit easier to quantify then the emotional aspect of risk. Tally up your annual debt payments (mortgage, car, credit cards etc.) and divide that by your anticipated annual income. That is your Debt-to-Income level (DTI) and is an important barometer for financial tolerance.
An ideal range for this for an individual is in the 28-35% range. This means that your current debt levels can typically be covered by your annual salary and there is some room for added risk exposure. Now, while your DTI can serve as a good base metric it is important to remember the scalers that are involved with your financial tolerance.
Multiple income streams are probably the most important feature of improving your financial tolerance. While, your primary occupation may be sufficient to cover all your current needs what happens if that goes away? The ability to rely on several sources of cashflow during turbulent times helps greatly as you continue to incur expenses.
Emotional Tolerance
Quite a bit different then your actual financials; your emotional tolerance is more simply put, your ability to stomach risks. To ride out the quite often turbulent roller coaster of market forces. While it is commonly understood that the economy always rebounds after a drop, it is another matter to remember that when living through a crash.
It is important to understand your ability to stay levelheaded, as when panicked you can make some foolish decisions that may hurt your returns or lose you money. How well do you think you will be able to react to seeing a plethora of red on your portfolio balance sheets daily or reading articles about the doom of the markets?
While that initial gauge is needed, it is more important to ask yourself how can you improve your emotional tolerance. After all, clear heads prevail in times of stress.
An initial path is to take a step back from your daily involvement. Market timing does not work, so not only do those daily checks hurt your returns they are also stressing you out. While, potentially motivational during a bull market seeing constant red every day can be demoralizing, particularly for an inexperienced investor. Instead remove the stock apps from your phone, check out from the financial news and return annually or quarterly to reallocate your portfolio to realign with your asset target.
Second you should educate yourself on market history. It is one thing to know that markets go up and down and it is another to understand the severity and relative quickness of a crash followed by a longer and more gradual resurgence. History may not always repeat itself, but it will certainly rhyme and understanding the rhythm of markets can make you more comfortable.
A final point of consideration is you can always expand your current emergency fund. Having an extra 3 or even 6 months of expenses stockpiled can do wonders for your mental state. Although you will hopefully never have tap into, simply having it as a resource is a reassuring ideal.
Final Thoughts
Risk is a feature of modern markets and personal finance. It can be scary at times, but risk aversion can hurt you. Not only limiting potential returns in your investments, but particularly in the major decisions that you will encounter in life. It’s often risky to make the leap and start your own business or to go into another industry that you are passionate in.
Risk does not need to be a coin flip decision. It can be calculated to allow you to fully capitalize on the choices you encounter that could be truly life changing decisions. Do not allow fear to immobilize you from making a risky decision. Thoroughly evaluate your situation with our helpful guide and take control of your life.
