Stock Investing: Know Your Risk Tolerance

 

Each one of us is a unique person, with investment philosophies that most likely differ from our friends, neighbors, and others in the investment community. So it's absolutely critical to know yourself, and understand your risk tolerance. Especially since the two emotions of fear and greed tend to drive the majority of investment decision making. When it comes to fear, we don't want to lose our money. But we want to make money, and that is where greed comes in. Those aren't bad emotions to have - we just need to keep them in check.

As I discussed in Small Cap Investor Daily last week, the liquidity issues associated with small-cap investing are unavoidable. However, these are manageable through application of the right stock order formats, diversification, proper timing of decisions, and averaging techniques. If investors have a single complaint or concern about small caps, it inevitably relates to the volatility of these stocks and their perceived risk.

Dealing with this price volatility is equally as challenging as picking the right stock. Stop-loss and trailing stop orders can only go so far in protecting you against the market conditions so often experienced in highly volatile small cap stocks. You have to ensure that the selections you make are appropriate matches for your personal risk-tolerance level.

Making it Personal

Personal risk tolerance is different for everyone and far more complicated than the common belief that all investors are the same: They want profits but not losses. On examination, you quickly realize that risk tolerance is more complex, and just as important, it changes as your investment exposure, age, income, and experience all evolve.

Risk tolerance varies based on many factors, and no two people are going to be identical in how they define this for themselves. These factors include:

1. Age.Most people understand that the longer the time to retirement, the more risks they can afford to take. And the shorter that time, the more they need to preserve capital. Although these generalizations are true, your age has more to do with risk than just counting the number of years to retirement.  You also will want to consider your priorities, based on your age. For example, you might be looking forward to eventually breaking out of the corporate grind and starting your own business; if you are planning for this, you might have a target date in mind, and this certainly affects the level and degree of risk you are willing to take.

2. Income and assets. Your current level of income and assets directly influences risk as well. If you have adequate income to put aside a sizeable dollar amount each month to invest (your disposable income), then you are naturally going to be able to live with greater risks than others. Some people barely get by on their income and cannot afford any risk. Your assets also play a part. If you have considerable assets, this affects how you look at risk. If you own a home and have a mortgage, the cash flow including that mortgage payment affects risk; if you own your home free and clear, the investment possibilities are greater and your risk horizon can expand as well.

3. Experience and knowledge. The degree of your own experience and knowledge is very important in deciding your appropriate level of risk tolerance. The greater your experience, the better you comprehend the direct relationship between risk and profit potential, and the greater your knowledge as an investor, the less fearful you are of otherwise unknown risks. These two working together-experience and knowledge-define how risk tolerance is going to evolve as your exposure changes, your income and assets grow, and your life situation changes over time. The past experience of each investor also impacts that outlook and risk tolerance. For example, investors who have survived a bear market and experienced a recovery in the stock market are likely to be more tolerant the next time stocks head lower. And those inexperienced investors who have never been through the bad times are more likely to throw in the towel when the going gets tough.

4. Investing venue. You may invest differently in your personal accounts than you do in your IRA or other retirement plan. You may also adopt different risk postures when buying stocks directly versus buying shares in a mutual fund. This is true even when some stocks have lower market risk than some mutual funds. It is wise to understand how the venue affects your attitude toward risk, and how this reality might distort your perception of risk tolerance.

5. Tax situation. If your income is higher than average, your income tax burden is always on your mind when you invest. The tendency is to seek investments with tax-deferral provisions, to defer selling profitable positions until the following year, and even to seek investments with less potential just to keep the tax burden down. The tax burden is aggravated when you are subject not only to federal taxes, but also to high state taxes or even a municipal income tax. Be aware of how positioning yourself as a small-cap investor will affect your tax liabilities, but don't allow tax considerations to affect how you otherwise make risk evaluations, pick stocks, and time your buy and sell decisions.

6. Family situation. Your family situation also affects the degree of risk you are willing and able to assume. A young, single professional with plenty of income, no mortgage payment, and many years before even thinking about retirement will probably have a vastly different risk-tolerance level than a married investor with a spouse, children, mortgage, and car payments, who has no immediate prospects to free up disposable income during the next few years.

7. Major life events. I know that all of us have to change our risk profile based on the major changes in our lives. These include graduating from college, landing the first job, getting married, buying a home, having a child, paying off a mortgage, starting your own business, paying for a child's college education, and retiring. All of these are positives. On the negative side, life events can include bankruptcy, divorce, loss of a job, poor health, and the death of a loved one. Some of these events can be mitigated through insurance, while others are unavoidable and cannot be planned for, but when they occur, they certainly change your risk profile in significant ways.

Small-cap stocks tend to be much more volatile than large-cap stocks, so understanding risk tolerance is especially important for the small-cap investor. At the end of the day, you are the one making the decision to buy and sell stocks. So make investment decisions with your personal risk tolerance in mind, because it is likely different than the risk tolerance of others in the investment community.