February 19,2003

Determining your Risk Tolerance
by Marcel Chartier

I have been watching the markets, the media, and the response of individual investors since the tech market collapse and the impact of the current bear market. I have been trying to figure out a way to enable anyone to determine their risk tolerance level. I have concluded that there really isn’t a scientific way to do this, it must be a mental exercise, it has to be done through knowing yourself and knowing what you can handle.

There are a few techniques you can use to help understand you risk level, the primary one is to image that you have a certain amount of money invested and picture how you feel when you have lost 50%, 40%, 30%, 20% and 10% of that amount. Vary the amount, always start with a large amount, $100,000 or more, then reduce the amount to $80,000, $50,000 then $25,000.

So, picture you have a cheque for $100,000 in your hand - doesn’t that feel good. You can ensure a better future for yourself, maybe take a trip, eliminate debt. You close your eyes and open them and look at the cheque in your hand, the number on the cheque has changed and is now $50,000.

How do you feel?

What plans have just been effected?

How does that make you feel?

Now do that by imagining losses of 40%, 30%, 20%.

Now do that with less money. Try $80,000, then $50,000. Be serious, go through the process. What you will find is that thought of losing 50% of $100,000 is appalling, but losing 50% of $25,000 has less impact. But guess what, when you are building a portfolio you are probably thinking yeah I can take a 50% cut, or a 30% cut. I can accept that risk, because the amount is less. But, as we found out during the tech bubble, the portfolios just kept on growing and that 50% risk is now potentially affecting larger and larger amounts.

The other contingency is the environment in which you are making a decision, if you are making decisions regarding your risk level in an environment that is positive, you will overestimate you ability to take on losses. If you are in a negative environment, you will overestimate your potential risks and potential losses. So imagine how you feel losing 50% of your portfolio after a market crash, during inflation, threat of war. That situation may potentially be the worse case scenario. After all that imagining, you should have a better idea of what your risk tolerance level really is by evaluating how you feel after the impact of potential losses.

Determining your personal risk level is more or an art than science. Your tolerance of investment risk will vary depending on the overall economic environment, the amount of money you have invested, the amount of money your are making or losing at the time. You will feel reasonably confident in any market environment as long as you are aware of what your ultimate level of risk is, that is: you are alright with the level of risk identified in your portfolio as reflected in both potentially high and low market conditions.

The flip side of identifying level of risk is being able to feel OK in letting market gains go by. There will always be the next hot stock or sector, and you will be tempted to get into that hot stock or sector to “not miss out” on the gains. Forget it and stick to your original plans, because the hot stock or sector will change, the market will change, and you may find yourself over there where the market moves over here. Building a solid portfolio is the other essential method of mitigating risk. Buying good companies with long term track records is another method of balancing risks with rewards. Maybe more about that later.