Risk management is the key to a successful investment strategy
There are many resources that offer investment advice on what you should buy now to thrive in the year ahead. The likelihood of these recommendations catching your attention may be high, but the likelihood of the choices turning out to be wonders in the marketplace is low. In the interest of your long-term financial security, focus on early 2022 by gaining insight into yourself that can make you a better investor without having to find the right investments to own.
Critical insight is understanding your relationship to risk. How well do you tolerate it? Can you afford to take it? How will you react when you are faced with risk head-on in your account balance?
Many investment education programs and financial advisers will offer you to assess your tolerance for risk by answering hypothetical questions or questions about how you have reacted to investment results in the past. Understanding tolerance can help you gauge your willingness to accept unknown results in exchange for the possibility of a future return on your investment. It is a relatively immutable measure.
Risk tolerance assessments do not help you understand your ability to accept risk. Whether or not you can afford to take the risk depends on the size of your investment assets, your income sources, your age, your expensesâ¦ a variety of things that change over time, making risk capacity a variable factor that requires the attention of a comprehensive and ongoing financial plan. Given the strength of stock returns in 2021, your ability to accept risk in your portfolio may have changed as we head into 2022. Your tolerance for risk may also have improved. People tend to view investment markets as less risky when they are going up and riskier when they are going down, when in many ways the opposite is true.
While your ability to take risks has increased and you are tolerant of it, that doesn’t mean you need to increase the risk level of your investments until you understand the third component of your risk ratio. .
You can be comfortable with your tolerance for risk and your ability while being both overwhelmed by what psychologist and behavioral finance author Daniel Crosby calls your risk-averse composure. It is at extreme times in the investment markets, both for better and for worse, as fear and greed become influential, that you need to understand how the emotional element of running your business becomes. life savings influences your decisions. If you have little self-control, you may be likely not to stick to your investment strategy during times of stress or excess. The best investors have a high level of composure amid the ever-changing landscape of investment markets, the global economy, and personal factors that impact financial security.
If you know you are sensitive to times of lack of composure, especially if you also have low risk-taking ability, you can design an investment portfolio (or work with an advisor to do so) that limits the risk. the likelihood that you will find yourself in times when you are tempted to choose another path, perhaps at precisely the wrong time.
The investment industry typically communicates on risk-adjusted returns when trying to optimize the risk / reward profile that best suits a particular investor. What might be more helpful, Crosby says, are anxiety-corrected returns. If you can design and implement an investment strategy that can reduce exposure to stressful times when risk becomes more evident, you will be much more likely to stick with your strategy.
Even if you sacrifice some potential return in exchange for less anxiety, you can build wealth. The magic of compound returns is not so much to get periodic exceptional performance from your investments, but simply to maintain even average performance for a long time. As Howard Marks wrote, âThat doesn’t mean good returns don’t matter. Of course they do. Just that they matter less than how long your returns can be earned. Excellent for a few years is not as potent as good enough for a long time. And few things can beat the average for very long. The only thing that matters is where you are in the long run.
Make 2022 the year in which you embark on a documented financial plan and investment strategy that incorporates an intentional assessment of your personal risk characteristics. Rather than continuing to search forever for successful investors who can overcome your investing behavior, consider reading âThe Psychology of Moneyâ by Morgan Housel or âThe Behavioral Investorâ by Crosby. You may learn about yourself and your relationship with money that will help you manage key life transitions over time.
Gary Brooks is a Chartered Financial Planner and the Chairman of BHJ Wealth Advisors, a registered investment advisor in Gig Harbor.