Talking to newbies about investing is like explaining sex to a virgin. You can describe it, but you can't capture the full experience.
When preparing an investment plan, it's necessary to work out a client's risk profile. This is based on a number of factors, such as cash flow needs and their psychological tolerance for risk.
Another way of framing tolerance for risk is to put it in terms of your ability to sleep at night when things are volatile.
Some people naturally have a higher tolerance for risk than others. Many people consider themselves to be somewhere around the middle, but there are always people at both ends of the spectrum.
There are some clients who identify as being risk averse. There are also some people who are especially tolerant of risk (the "risk seekers"). (Something that's common to many of these "risk seekers" is that they have stories of other family members, usually from one side of their family tree, who are similar to them. The stories about these family members are usually entertaining, and of a boom-and-bust nature. It's rarely one story, too.)
Risk tolerance isn't just based on your natural propensities. There are other factors that go towards your tolerance for risk. For instance:
- Understanding and knowledge makes a big difference. Once people realise that all types of investing involves risks – such as the risk of short-term volatility versus the risk of probably ending up in a worse position over the long-run, they often start to think in more nuanced terms.
- Perception of risk is also relevant. This is associated with understanding and knowledge, but there are other factors at play as well. One of the big ones is exposure and direct experience. Many clients don't perceive investing in property to be risky, because it's what they're used to. If they've never invested in shares, it seems dangerous, even if they're more widely diversified and can easily be turned into cash.
- Experience plays a part as well. Some people have really good experiences with certain types of investments which can blind them to the downside. Some people get stung with certain types of investments, and that creates something of an "ugh field" around that type of investing.
It's not just their own experiences that are relevant, as well. Many people have seen loved ones go through good or bad experiences and this shapes their level of comfort with certain investment approaches.
In order to identify someone's risk tolerance, and therefore their risk profile, I find myself asking lots of questions. In some ways, I feel like I'm asking the same question in lots of different ways until I have a picture of how that person ticks.
The problem is, these questions are hypothetical. I can try to get them to imagine different scenarios, and try to get them to step into the shoes of an actual downturn. But they are always hypothetical.
It's like explaining sex to a virgin.
Ultimately, you don't know what your risk tolerance is until it's tested.
In a recent post I mentioned that your financial plan might need to change if your circumstances, needs, and objectives have changed in light of everything that is going on.
Another factor is that you might have also discovered something about your tolerance for risk.
If you're not sleeping at night, and you're feeling a lot more anxious about your investments, then perhaps you're invested too aggressively. Based on this new information, you can update your plan to factor in your new understanding tolerance for risk.
The caveat is: you need to invest more conservatively at all times, not just when a downturn hits. Because you can't predict the timing of these things.
Likewise, if you're less worried than you thought you might be, then maybe your tolerance for risk is higher than you thought. It might be worth investing more aggressively.