As I am writing these lines, I am watching the TV Show “Billions”. The 3rd season just came up on Netflix and I am bound to my bed due to an unfortunate dengue fever infection, thus the perfect opportunity for some entertainment.
Watching “Billions” I can’t help but wonder about the life-style of the top 1%. These super rich individuals don’t impress me by their expensive cars, big houses or the fancy restaurants or the cigar clubs they visit. What is rather impressive, however, is their determination, competitive spirit and extreme risk tolerance to stay ahead in the game of money.
Sure, it’s just a movie, but from my own past working in a bank AND from what we know about the last financial crisis, we do know that there are indeed such people – cheating their ways to riches in unscrupulous ways, always with one leg in a prison and the other chasing for the next opportunity…
Which brings me to the point: How do we estimate our own risk tolerance?
Low risk offers low opportunities. But higher risk & higher stakes can produce significantly higher returns.
So what is your risk level? Understanding your own psyche is so important, because after understanding your risk tolerance, the next step is to align your expectations on returns, your investment methodology and your required contributions to your risk tolerance.
I.e., if you prefer to be cautious with your money, then stocks might be not immediately the right investment vehicle for you. Stocks go up and down every day, sometimes more, sometimes less. It takes time and experience to learn to be able to deal with this emotionally. Let’s say you put 10.000€ in a stock account, put it all in into a few selected companies – and when you wake up the next morning, the value might have slipped down to 9.500€. Will this make you sweat? Will you worry and start checking your account every hour or so to see whether these losses are going to turn back into profits? What if the market drops and your stock value goes down another 500€? Can you still sleep well at night?
Say you prefer to work with bonds that produced historically 3-4% lower returns than stocks. This would mean that to reach the same target within a similar time-frame, you would need to save/invest more to realistically expect to hit the same target.
When reaching for FIRE, checking for your actual risk tolerance might be the wrong approach though. Instead, you might need to ask yourself how badly you really want it, and accept to go for a higher risk level.
Risk tolerance can be trained
Now the good news is that as humans, we are highly adaptable and the more often we expose ourselves to risk factors, the faster we may be able to learn to manage those risks.
Watching your stocks drop the first time can be an emotional experience, but after a while, seeing your portfolio going up and down day-in and day-out, you might not care about those short term changes at all. What kept you awake at night on the first day won’t bother you once you gathered some experience, even if the concerning factors at play grow larger.
So, when is it enough risk? Certainly it’s something that everyone needs to discover by and for oneself, but don’t dismiss stocks just due to a lack of experience or because you think they are a risky investment. At the end of the day, managing risks means, among all, to manage our emotions – and the better we learn to do that the easier it will feel to go for opportunities once they reveal to us themselves.