Risk tolerance: The sales tool

Some investment promoters claim they have all this covered. They ask you a series of questions about your risk tolerance before they sell you their products:

• “If the market declines 25 percent in one year, will you take your money out?”
• “Are you able to keep the long-term in mind when markets

fluctuate or are you more comfortable with investments that do not fluctuate?”
These tests determine your so-called “risk tolerance.” Risk tolerance is your ability to handle volatility. Risk tolerance tests are supposed to match you to compatible investments. Unfortunately, they don’t. Risk tolerance is not a good measure of investment compatibility. At best, it measures a narrow aspect of your personality: your theoretical ability to handle volatility. Even if your broker happens to sell the product that is theoretically right for your risk profile and you buy it, studies show that how people think they will react under adverse market conditions and how they actually react are quite different. In fact, few of us know ourselves well enough to know how we would really react in future unknown situations. The real problem is that risk tolerance tests do not touch the crucial issues: who you are as an investor and how investments interact with your personality. For example, they do not address the issue of the adverse relationships you have with the investment seller and others. In fact, they disguise this issue. These tests lead you to believe that you and the salesperson have the same interest. The tests do not address the issue of overconfidence. Overconfident investors believe they have high risk tolerance when they do not. The tests do not address the issue of people pleasing. People pleasers are often aware that they have low risk tolerance but they buy high risk investments to make their broker or their coworkers happy. In fact, risk tolerance tests do not accurately address any of the issues that will lead you to purchase incompatible investments.
Risk tolerance tests are equally ineffective for average personalities and for extreme personalities such as workaholics, gamblers, and compulsive debtors. Extreme personalities typically have little or no self-knowledge. They will fill out risk profiles identical to those of average investors. Yet once sold an investment product, they will abuse it to a degree unimaginable by the average public. Risk tolerance tests do not pick up money addicts of any kind and lead to no help for these people or those affected by them.
While money addiction is more prevalent in our society than most people realize, the vast majority of investors suffer from less extreme forms of investment incompatibility. The more common symptoms include loss of sleep, irritability, unexplained anger or depression, random resentments, a sense that investing is meaningless, money arguments with a spouse or partner that neither can comprehend, a dim view of retirement possibilities, and a thousand forms of fear.
The major investment fears are that you do not have enough investments now, won’t have enough in the future, or will lose what you already have. Then these fears lead to further fears. If you don’t have enough savings, then how could you have enough money for travel, clothes, restaurants, a new car, a better house, a real life? Or you fear you cannot and will not ever grasp the mathematical complexities of compound interest and probability theory and you cannot trust those who do understand these concepts. Then there is the underlying fear that investing is irrational and no amount of study will help.
The premise of this book is that these feelings and fears are normal and healthy; understanding them and understanding the emotional hooks of different investments will lead to a greater sense of peace and contentment in your life. They don’t sell peace and contentment on Wall Street. You have to find it within yourself first and then look for the investments that enhance it, rather than disturb it.
When you know more about yourself and about the products that are out there, no risk tolerance tests with hidden agendas will sell you incompatible investments anymore. Investing will become an area of great satisfaction in your life.

Understanding investment compatibility

Investment compatibility becomes a possibility when you first admit that investing triggers difficult emotions. Try this series of questions and see if you relate to any part of the emotional dilemma:

• Have you ever found yourself losing sleep over the market, angry with your broker, unsatisfied with your returns, yet unable to pull out of the market?
• Are you jealous of your business associate who has turned it all over to a money manager and has no idea how he is doing?
• Does the woman across the street with her string of singlefamily houses irritate you?
• How did you react when that 35-year-old coworker retired?
• Do you value honesty yet find you have lied to several people about your investments and investment returns?
• Do you seek serenity over financial security?
• Will high returns bring you serenity or just increase your craving for more high returns?

The more you look at it, the more emotionally charged investing becomes. Financial advisors discuss risk as risk of losing money. Isn’t the real risk emotional? If you are not in the stock market, you risk being an outcast at the beach gatherings this summer. But if you are in the market, you risk losing sleep and losing time trying to keep up with how you are doing, how the market is doing, and how well everyone else is doing compared to how you are doing.
If you knew yourself better and knew more about the emotional aspects of different investments, investing would be more satisfying. Try this question. Is it easiest for you to trust people, financial markets, or the U.S. Treasury?
Those who have a hard time trusting people will find that turning their assets over to a money manager or a stockbroker creates fear. Many independent business people founded and built up their own businesses because they only really trust themselves. That is fine. If you are like that, yet you have turned your money over to a money manager, you will be uncomfortable even if the money manager produces outstanding financial results. You will be happier making all your own investment decisions even if it costs you money.
Some people cannot trust financial markets. Perhaps you saw your parents lose a fortune in stocks. In that case, you may be more comfortable receiving interest payments from Treasury bonds, even if you could make more money in stocks.

Investing triggers many emotions

To be comfortable saving for retirement and spending savings in retirement, your investments must satisfy both your financial and emotional needs. When your investments are lucrative, but you and your investments are not emotionally compatible, you will either get rid of them and look for something new and possibly more incompatible or stew in your misery. Yet it is difficult to even know what your needs are in this relationship. You are subject to great cultural pressure today to own U.S. stocks, especially the latest fad stocks. It is not just that everybody at the office claims to own them and is checking the results online all day. There are whole institutions devoted to this: CNBC, The Nightly Business News, The Wall Street Journal, a thousand Web sites, and chat rooms. The pressure to own stocks so you can converse about them is high. But are you happy with them? Is anybody happy with them? How many of your colleagues have stopped to ask what their emotional needs are in their investment relationships? Do they act like they know what their emotional needs are? Let’s return to the question that started this chapter and look at the emotional dilemma apart from the financial. What emotions are triggered by having to choose between retirement savings and vacations? Do you find yourself feeling guilty when you go to Hawaii instead of putting the money in an IRA? Or do you get depressed when you cannot go to Hawaii because all your extra savings are tied up in IRAs and other retirement plans?

How to Evaluate Whether Changes in the Budget Are Necessary?

If there are large variances, or your surplus/deficit is not what you would like, you need to analyze your budget. Examine the variances and study where the amounts spent are greater than the budgeted amounts.For example, if your actual utility bills are consistently greater than the amounts budgeted, then you need to either reduce your utility usage, if possible, or increase the amount budgeted for this item.When you increase planned spending, you will need to find items where you can make corresponding cuts to compensate for the increases. If you don’t, the amounts set aside for personal goals or savings will be reduced. There are certain expenditures over which you have some degree of control. These are your variable expenditures, such as entertainment and miscellaneous expenses. Entertainment and food are the most common areas of overspending, particularly when they involve eating out at restaurants. By contrast, fixed expenditures such as rent, mortgage payments, taxes, and insurance premiums cannot be easily trimmed without undue consequences. Deficit spending may be more difficult to remedy when you have already reduced many of your unnecessary and variable expenditures. It then becomes more difficult to cut essential spending items. If spending still exceeds income after revising spending amounts, you need to reevaluate your entire budget. Perhaps you have created too tight a straitjacket for yourself.Revise your goals and set aside amounts to attain them before allocating the rest of your income to your expenditures. You may need to prioritize your expenditures to see which are necessary and which can wait.
The purpose of a budget is to help you plan the use of your resources so that you can fund your goals and set aside more of your money to savings. Following your budget will help you achieve what you want most from your resources.

How to Record Actual Income and Expenditures for the Period Budgeted?

Actual amounts earned and spent are not always the same as those projected. By recording the actual amounts and comparing them with the budgeted amounts, you can immediately see the differences, called variances. Spending more than a budgeted amount for one item can be offset by spending less than the budgeted amount for another item.
Similarly, if actual income exceeds actual expenditures, there is a surplus, which means additional cash. The opposite is a deficit, which means that cash will have to be withdrawn from cash savings or other assets in order to pay for the deficit spending.

How to Determine Whether There Is a Surplus or a Deficit?

If budgeted amounts for income exceed expenditures, there is a surplus. Expenditures and the amounts needed to fund personal goals added together equal the total expected expenditures. It is a good idea to incorporate goals into a budget so that monthly or periodic income is set aside to address them. When projected income exceeds projected expenditures, there will be additional amounts of cash, which can then be added to savings/investment plans or used to pay down liabilities.
When projected expenditures exceed projected income, there is a deficit. This means additional amounts will have to be withdrawn from savings/ investment plans to pay for these additional expenditures. In such a case, it may be necessary to review projected expenditures and reduce some of them, or look for ways to increase projected income.

Determine Your Financial Goals

In order to set aside money for your financial future, you need to estimate the expenditures that go toward your savings and investments. Financial goals vary from person to person over time. Some financial goals are:
• Saving for an emergency fund
• Increasing savings and investments
• Buying a new car
• Paying off a loan
• Buying a house
• Buying a larger house
• Saving to fund children’s education
• Providing retirement income
• Saving for annual vacations
Some of these are short-term goals while others are longer term. It is often easier to concentrate on the short-term goals and neglect longerterm goals. By assigning priorities to each of the goals and quantifying their cost, you can determine the amount of savings needed to fund them.