Psychology of investing: Understand your own risk tolerance
Click Here to Manage Email Alerts
Key takeaways:
- Recognize how emotions such as envy, fear, regret and excitement may impact your investment decisions.
- Maintain a diversified portfolio consistent with your risk tolerance.
Investing, compound interest, dollar-cost averaging — these concepts seem more mathematical than mental.
The same is true for investment strategies such as the ratio of stocks to bonds, facilitated by easy rules such as, “one’s stock percentage should be 100 minus their age.” However, the psychology of investing is just as important, if not more important, to achieving financial success as understanding the math.
We all have our own built-in preconceptions about money and the degree of financial risk that allows us to sleep at night. Understanding your individual unique tolerance for financial variance is critical, especially as we navigate bull (positive) and bear (negative) markets.
Recognize emotions
For example, let’s consider the mid-career physician who has predetermined an investment strategy of investing $5,000 a month with a 70% stock and 30% overall ratio in broad-based, low-expense ratio index funds. Sitting in the OR lounge waiting for their next case, they overhear a colleague describing how they put all their money into cryptocurrency and have seen it more than double in the past 5 years. Moreover, the colleague expects it to continue doubling every 5 years. Our physician may feel several emotions: envy, fear of missing out on a windfall, regret and excitement at the possibility of doubling their money and possibly retiring early.
These emotions are important to recognize, as they all can modify rational and carefully construed financial plans. The eavesdropping physician may want to transfer all of their investments over to cryptocurrency, putting all of their eggs in one speculative basket. It is easy to recognize that chasing a gain after an investment rally violates the cardinal rule of buying low and selling high. Moreover, a nondiversified investment portfolio introduces significant downside risk if the asset class tanks.
Stick to your financial strategy
Let us consider the example of the young, bright-eyed, straight-out-of-fellowship new attending surgeon. This attending subscribes to a similar philosophy: They are going to invest in an index fund tracking the S&P 500 with an initial lump sum investment and automatic monthly investments. Given their time horizon to retirement is decades away, they decide to invest 100% of their portfolio in the stock market.
They intellectually understand that their initial $50,000 lump sum investment will indubitably grow by the end of their investment window, as will the monthly $5,000 automated transaction from their checking account to their brokerage account. However, 3 months later, the market crashes, and they find themselves feverishly logging in daily to check their account balance. When it drops below $25,000, how do they respond? Their brain might know to stay the course given they are a long-term investor, but their emotions will include anxiety, fear of losing all their money and anger. They may want to cut their losses by withdrawing their remaining investment and stopping their automatic investments. After all, why would they pour more money into a burning house? A decision to sell would be irrational — as they would be selling low — and incongruent with their original financial strategy, but one can understand why it can be so hard to weather the severe lows the market can bring.
If this example seems improbable, remember that the S&P 500 fell 57% from its peak in October 2007 to its low in March 2009. This type of variance is always possible with the stock market, even though we have largely experienced a bull market over the past 15 years.
The takeaway
Maintain a diversified portfolio with a stock-to-bond ratio consistent with your risk tolerance. Stay the course in up markets and down markets, and consider rebalancing periodically to maintain your prespecified asset allocation.
Are you worried about missing out on a potential hot stock or asset class like cryptocurrency? Feel free to include it in your investment strategy, but keep the allocation low — say 2% — to reduce variance in your overall portfolio. Do you have insomnia that a 100% stock portfolio exposes you to the possibility of a 50% or more decrease in your nest egg? Rebalance your stock investments with more stable bonds or cash-based investments; this reduces the volatility, return and sleepless nights. Because, in the end, even the most scientific strategy will not be fruitful if it does not comport with your individual investing psychology.
For more information:
Chirag P. Shah, MD, MPH, is a soccer and Nordic ski coach, who also practices medicine and teaches in Boston. He can be reached at cshah@post.harvard.edu.
Jayanth Sridhar, MD, is an award-winning podcaster, physician and educator who is chief of ophthalmology at Olive View Medical Center in Los Angeles. He can be reached at jsridhar119@gmail.com.
Collapse
Expert Submission
Read more about
Click Here to Manage Email Alerts