In the previous post, we looked at understanding risk in the context of first principles and everything you need to know about it. This time, we'll look at what you need to do.
Everything you Need to DO
1.Start with a Baseline Risk Tolerance Test
If you have never done one before, I suggest you start by getting your own risk tolerance measured. If you’re inexperienced in matters of investing, you won’t answer the questions from a position of knowledge. A proper, scientific test can help you with this.
The best place I know to get this done right now is from Finametrica. Go to https://meaningfulmoney.tv/myrisktolerance to get yours done. It’ll cost you £30, but don’t be cheap – this is important. If you can’t afford or don’t want to pay £30 for this, you probably shouldn’t be investing.
You may be asked about how those around you might perceive your willingness to take risks, which I don’t think is helpful. Don’t worry too much either if it rates you relative to the population as a whole, because you’re unique, as is your attitude to risk.
2. Learn What That Actually Means
Once you have an idea of your risk tolerance, you’ll get some kind of explanation of what that means. That’s your starting point, but don’t stop there. Next, you want to look at how an investment that fits into that risk profile might behave.
If you’re a balanced investor (according to the test), look for a balanced fund. This podcast episode might help. Find one in the 20-60% Mixed Investment sector – that’ll be something like balanced if it has around 50% in shares.
Now look back at the last 15 years of its performance. This will cover the credit crisis between 2007 and 2009. Don’t look at how it did in comparison to its peers, just what happened to its value.
How might you have reacted at the time? I know you wouldn’t have liked it, but if you had invested £10,000 and seen it turn into £6,500 would you have bailed out? If so, then maybe you’re not so balanced as you think.
Bear in mind timescale. If that money was in a pension and you’re 35 years old, you can’t get at the money for another 20 years in any case, so who cares how it performs in one three-year period?
You need to learn how an investment, supposedly suitable for you based on your risk profile, has actually behaved. Look back at the past 15 years’ performance and divide the percentage return to get a scratch average annual return.
If the fund has returned 90% in that period, divide that by fifteen years to get a 6% average return. That’s actually about right for a balanced fund. Get comfortable with the idea that funds don’t just go up but can go down.
3. Celebrate and Capitalise on Market Corrections
We need to reset our view on market corrections, which is why you need to get good at blocking out the media. During the credit crunch, the tabloids had headlines that caused panic, but I worked to counter those messages with my clients, and none of them bailed out.
Never mind hunkering down during a market storm, we should celebrate, and see a correction as an opportunity to buy more stuff at knock-down prices, especially when we’re in the wealth-building stage.
If we’re buying more shares with the income generated by our current investments, that’s great news, but maybe you can see why this is counter-intuitive. It’s not easy writing a cheque or pressing send on the bank transfer to put more money into an investment if all around you the messages are bad news.
This is the very definition of living by the great maxim of Warren Buffett, that ‘we should be greedy when others are fearful and fearful when others are greedy'.
4. Stay Alert to Other Risks
Risk is about far more than just the chance of markets going against you. There are risks to your plans due to unforeseen events like death or critical illness. There are risks from inflation and from inertia, where you are paralysed by indecisions and miss out as a result.
Risks are everywhere, but that’s not something to be afraid of. We need to man-up and face these risks and challenges head-on. We need to understand them, and then adapt to them, rather than running for the hills at the first sign of trouble.
It’s easy to forget that really, investing and wealth-building isn’t rocket science. Plenty of people have become wealthy before you and plenty will after, because they’ve understood and harnessed the relevant risks in their favour, and you can too.