When putting together a portfolio, the very first question you have to ask is what type of asset allocation you want to use — how much of your portfolio should be in stocks and how much in bonds?
And the answer to that question depends on how willing you are to take risk in your portfolio.
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Risk Tolerance Questionnaires
The most common way of assessing an investor's risk tolerance is to give them a multiple choice quiz called a risk tolerance questionnaire. Unfortunately, most such questionnaires leave much to be desired. You can get more useful information from a quiz in Cosmo.
The problem is that the questions are often designed in such a way that there's only one reasonable answer. So rather than learning anything useful about yourself, you simply proceed through the quiz, picking the “right” answer each time as if you were taking a quiz in school.
For example, consider this question from a real-life risk tolerance questionnaire:
“Imagine you inherited $1 million-worth of a single stock from a long-lost aunt. Would you A) hold the stock, B) sell half of the stock and invest the money in more diversified holdings, or C) sell all of the stock and invest the money in more diversified holdings?”
If you choose C, you're rated as a conservative investor. The problem, of course, is that everyone should choose C. Even super aggressive investors (who don't want any low-risk investments like bonds or cash) would be better off selling the stock and investing the money in a diversified portfolio of stocks. In most cases, holding $1 million in a single stock doesn't make you an aggressive investor. It makes you an idiot.
Using Real Life Experience
My best suggestion for determining your willingness to take risk is to keep a record of how you have actually responded to market declines in the past. For example, what did you do when the investment banks started failing in late 2008 and the market began to crash? How did you feel? What about a few months later, by which point the market had fallen by roughly 50%?
- Did you panic and move everything to cash?
- Were you sufficiently brave to hold on to your investments (but not brave enough to rebalance your portfolio back to your planned allocation, because doing so would have required selling bonds to buy more stocks)?
- Did you rebalance exactly as planned?
- Or did you smell the deal of a lifetime and move every single dollar into stocks?
What you actually did and how you actually felt during a real life market crash gives you meaningful information about your willingness to take risk — far more useful information than you can get from a multiple choice quiz.
What About New Investors?
If you're a new investor who hasn't been through a bear market before, my suggestion is not to worry about it too much. When you're first getting started, how much you invest is far more important than how you invest.
You probably won't get your risk tolerance and asset allocation precisely right on the first try. But that's OK. If the lesson you gain from your first bear market is that you under- or overestimated your risk tolerance, simply adjust your portfolio as needed and move on with your life, knowing that you've gained valuable information that will help you to better survive your next bear market.