Investing can be very fulfilling.
You’re putting away money for your future with the expectation of having that money produce even more money.
If you’re like most people, you hope that one day your savings will create enough money to replace your income, right?
The dream of logging into your investment account to see if you should have steak or lobster tonight (or both) sounds great but, before you get there, you’ll need to be able to manage your investment risk.
Most people associate investing with movies like “The Wolf of Wall Street” or “Boiler Room,” in which a bunch of young guys hit home runs with other people’s money and enjoy life to its fullest.
Reality can be quite the opposite.
After saving for years to have enough money to invest, you may watch your savings decrease dramatically within a matter of minutes.
This situation is common, particularly among new investors, but the heartbreak can cause you to make irrational decisions that could compromise your future net worth.
In this article, we’ll discuss how to establish your risk tolerance to avoid one of the biggest mistakes when it comes to investing: making emotional decisions!
According to DALBAR, an investment research firm, the average investor achieved a 4.79% annual return on their investments from 1996 – 2016.
During that same time, the S&P 500 index achieved a 7.68% annual return.
If both portfolios were $100,000 in 1996, the average investor would have $184,418 less than the investor who invested in an S&P 500 index fund and never touched it.
The lesson here is that it’s nearly impossible for the average investor to match or beat the returns of the S&P 500 (or any index).
Much of this difference comes as a result of investors making emotional decisions.
This happens when investors buy at the top and sell at the bottom of a market cycle.
The hysteria of the 24 hour news cycle along with the fear of missing out on the “easy money” causes people to make irrational decisions with their savings at the worst possible times.
It’s easy to be undisciplined with your money when things are going well.
However, having a set of rules and guidelines will strengthen your investment returns and can allow you to realize your goals.
Here are a few rules to refer to while investing:
Know Your Risk Tolerance
If you’ve ever had the displeasure of completing a risk tolerance survey you know that it can be difficult to know when you should pull some chips off the table.
The average risk survey includes about 20 questions asking you how you would react to different situations related to investing.
Based on my experience, these answers go out the window if you are 20 – 40% down in a position.
The loss of money (whether on paper or in reality) causes people to make excuses as to why the investment will not only return to the original price, but move beyond that level.
Your analysis of the stock’s ability to move higher could be completely rational, but the stock market doesn’t operate logically.
There are a number of different influences and participants that leave the market operating at the whim of whatever the price movement is at that particular moment.
Simply put, the price at the moment is what people are willing to pay for that stock at that particular time.
If you’ve invested for a while you know that a depressed price can remain for weeks, months and even years before moving up.
In order to limit the loss on your savings from an investment or to avoid having your money trapped in an investment for months due to a drop in price, you should complete a risk survey to know what your comfort level is regarding your investments.
Most risk surveys operate in a hypothetical world without much practical application to an investor’s situation, however I have found that this risk survey is more applicable to the average investor.
By reducing the number of questions you have to answer it makes it easier to focus on the questions at hand.
This survey also has the benefit of quantifying your risk tolerance in dollar terms.
I have found that having a dollar based risk tolerance makes investing much easier for people.
Now, when they look at their portfolio risk they’re looking at how that risk relates to their annual salary or overall savings.
When deciding on an investment’s risk they can gauge if it’s appropriate pretty quickly.
Click here to take free your risk survey.
Record Your Stop Limit
Now that you’ve established the risk tolerance for your total portfolio(savings), you’ll want to define your stop limit as it relates to any one position(investment).
Having this number available will give you a framework to operate within while investing.
With a stop limit you’ll now have clear guidelines as to when you should reduce the size of a position or get out of it completely.
This avoids you hanging on to a position for too long.
Now, if you’re down on a position you know how long until you cut it out of the portfolio.
For example sake, let’s say that you have $10,000 to invest.
You’ve decided that the most you’re willing to lose is $5,000 before pulling completely out of the market.
]f your stop limit is 10% then you know that is the maximum amount you are comfortable losing in any one position.
So, your rule would be that if you lose 10% or $5,000 (whichever is greater) on any one position you have to get out.
Using this technique you’ll always feel like you have greater control over your investments because you’ll operate in a proactive manner instead of being reactive.
If you want to get more detailed with your rules, you can decide to cut your position by 50% if it drops by half your stop limit or reduce the position incrementally based on what’s appropriate for you.
Whatever the rules may be, be sure that you write them down and post them next to your computer.
These rules should be around anytime that you make decisions in your investment account.
Understand the Market’s Direction
It can be easy to feel like the market’s against you at times, but remember the “market” has a global value of $69 Trillion dollars according to Visual Capitalist.
This includes the funds of governments, charities, foundations, businesses and individuals.
With this much money at stake there are bound to be forces beyond your control.
Having a good grasp of this will allow you perspective to look beyond your situation when making investment decisions.
At any given moment there can be geographic, political, demographic, interest rate, industrial, economic and thousands of other different forces impacting your investment performance.
Each of these factors operate within their own cycles and can impact your ability to generate a positive return.
Your opportunity as an investor is to ride the current of these different factors and cycles to grow your savings.
As simple as it may sound, it’s easier to fly with the wind at your back then it is with the wind blowing in your face.
This “wind” may be forces like Central Banks printing money out of thin air and buying stocks (like the Swiss National Bank, Bank of Japan and European Central Bank who have already bought over $1 Trillion of Assets in 2017)
You may think that it’s unethical for a private group of individuals who have no government oversight to be able to counterfeit money and then use that money to purchase real assets in companies that produce real things.
Unfortunately, that type of logic no longer has a place in the markets.
In order to avoid losing your shirt you have to go with what the market is telling you on a daily basis.
You can do this by learning to interpret the overall market direction by reviewing the daily market indices’ price and volume movements.
You’ll also want to pay attention to the market leaders and their daily fluctuations.
This can determine if you win big or lose.
Stay in gear with the market.
By now you should have a sense of the different types of risks in investing and how you can manage them to your advantage.
I encourage you to go through this article again and then begin taking action.
Define your risk tolerance, write out your rules, and then build a regiment to measure risk daily.
By doing these tasks you’ll put yourself in a stronger position than most investors and even some money managers!
Have you ever made a risky investing mood? Did it benefit you in the long run or do you regret taking the risk? Let us know in the comments.