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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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There are two basic financial risks to investing: the risk of losing your money and the risk of losing an opportunity to make moneyKnow Your Risk Tolerance At 3,000 feet, hands on the wing strut, wind in my face, I pushed into space. Spread-eagled, I shut my eyes and prayed! Thankfully, the static line automatically opened my chute. I was alive and euphorically floating to a successful landing. It was 1962 at a New York parachuting center. We were four guys on a dare. After an hour of training, two of us had the courage to jump. The other two became lifelong chickens. Three months later, I heard that a fatal accident occurred at the parachute center and it was forced to close due to alleged safety violations. Be that as it may, I never jumped again. I learned a lot about risk from that experience. The risk in jumping is losing your life. But the first-order riskin life and in investingis in not understanding risk. If, after reading the preceding chapter, you believe you are ready to make a commitment to investing, and if you believe you have the courage to stand by that commitment, then you need to be prepared to take some risk. What exactly does that mean? Let me be as clear and direct as possible. There are two basic financial risks to investing: the risk of losing your money and the risk of losing an opportunity to make money. The two risks are in conflict. If you try to make money through certain investments, you could lose some or all of the money you invest. If you keep your money completely safe, you may miss out on the chance to earn good returns through investing. The challenge of investing is to try to give yourself the chance to make money while minimizing the risk of loss by building in downside protection. Thats what a good defense is all about. Beyond the risk of lost money and the risk of lost opportunity, there is a third risk you must consider: the psychological risk that you cant handle the amount of risk youve taken. I call this your risk tolerance. A game plan must strike the right balance for you between the two financial risks given your personal risk tolerance. As Ill explain, how to balance the two financial risks depends largely on your goals, the subject of Chapter 3. Step 2, this chapter, is figuring out your risk tolerance. As with Step 1, part of this analysis depends on your beliefs. The Guesswork of Risk I advise people about risk nearly every day. But even for professionals like me, there is a lot of guesswork with risk. Since risk is all about what will happen in the future, the outcome is uncertain. They say you cant get reward without risk, but just because you take risk doesnt mean youll get rewarded for it. Even though I spent seven years as an Air Force officer, I cant personally measure or prevent all the risks in flying. I have faith in the numbers that seem to say its safer than driving, and I trust a pilot and crew. But I still say a little prayer going down the runwayand did so even before 9/11. What gave you the courage to do something that scared you? It probably had something to do with faith and trust. Theologians define faith as the substance of things hoped for and the evidence of things not seen. Trust is when you believe that somebody, including yourself, can and will do the right thing. You have faith in a result and trust in somebody to make it happen. This chapter is about helping you figure out how much risk you can handle so that when you create a game plan youll be able to trust yourself to stick with it, and youll have faith that it will be worth the risk. Your investment portfolio carries risk. You have a certain risk tolerance. The question is: Does your investment portfolios risk match your risk tolerance? Too often the answer is no. Rather, theres a gap between the two, as financial planning researcher ProQuest describes it. My goal as a planner is to help you close the gap, that is, to help you align the risk profile of your portfolio with your risk tolerance. To close the gap, you first need to identify how large it is. That task involves knowing both the risk profile of your portfolio and your own risk tolerance. In later chapters we discuss the risks of various investment portfolios. This chapter is about sizing up your personal risk tolerance. This chapter includes a quiz that I believe can help you evaluate your tolerance for risk. But its not the only quiz out there. In fact, ProQuest, based in Australia, has come up with an excellent 25-question riskprofiling questionnaire for individuals. The ProQuest web site, www.proquest.com.au, is accessible by subscription, and the cost is a hefty onedesigned to be borne by professionals, who can then give their clients the questionnaire. If you are working with a financial planner, ask whether he or she has heard of ProQuest. If the planner is a ProQuest subscriber, take the test, and discuss it with your advisor. Youll both learn something, and youll get closer to closing that gap. The No-Risk Stash Before talking about what you can risk, we have to talk about what you cant risk. None of us ever wants to lose money, anytime. But certain money we simply cannot afford to lose. If we were to lose it, we could lose our home, we could lose our car, we could be forced to scale back on the basic day-to-day expenses that support our lives and our families. You may recall earlier that I talked about financial planning as holistic, about how you cant entirely separate issues like cash-flow planning and mortgage responsibilities from your investment decisions. Risk planning is one of the times when that overlap comes into play. Before thinking of how much risk you should take in the stock and bond markets, you need to decide what portion of your funds doesnt belong there at all. This determination may depend on factors such as your job stability, your daily financial commitments, your near-term plans for major purchases like a home, or your emotional needs for financial security. The basic rule of thumb is that you should not put at risk money that you may need in the next five years. Thats because historically a broadly diversified portfolio of U.S. stocks and bonds has produced positive returns over the vast majority of five-year periods, according to data tracker Ibbotson Associates, Inc. If you can wait five years to cash out of a broadly diversified portfolio, odds are very good that youll come out ahead. If you cant wait that long, you may end up having to sell when prices are at an ugly low. (That goes for bonds, too; their value doesnt always go up.) If you have to sell after a short time period, you might not come up with the amount of money you need. So before you think about the extent of risk you can take, you have to set aside the funds you cant risk at all. Reasonable versus Extreme Risk Once you have a sense of the funds you can spare for investing, youll need to decide just how much risk to take with those funds. Unfortunately, all too often people skip this step. They think of investing money like gambling money. Once they decide how much theyre willing to play with, theyre willing to risk it all. The second-largest tourist attraction in the world is Las Vegas. (The first, by the way, is Mecca.) And thats no coincidence. Vegas is all about short-term thinkingthe most natural way to think when it comes to money. In Vegas people roll the dice, spin a wheel, pull a handle, or play a hand, and voilinstant gratificationwin or lose! The builders of the Vegas casinos knew how to stack the deck in their favor. Sure, theres some skill involved, sometimes. But most of the time if you win it is because you are lucky. Most of the time people take huge risks and sustain huge losses. You rather have 50 percent chance at 10 $ or an 80 percent chance at $8? Although most people would pick an 80 percent chance at $8, thats not how they invest. They dont pay attention to the risk fund managers take to get the returns they post. Sometimes $8 is better than $10, if it means youre not jeopardizing your principal. Give risk its due, because the less you take, the better chance you have of not losing or at least not losing as much. If you want the instant gratification that comes with gambling, do it in Vegas. The only way to get immediate gratification in the markets is through extreme risk, like betting a bundle on one small up-and-coming stock or one white-hot sector. Extreme risk is like roulette: It offers a chance at a super-high return if you bet right, but there is also an extremely high chance of total wipeout. |
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