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Your Emotions Rule How You View Investment Risk

10/21/2014 01:22 EDT | Updated 12/21/2014 05:59 EST

Every time you sit down with an investment professional, you are asked what your risk tolerance is. Despite how common a question, answers vary wildly because both they and their clients understand something slightly or significantly different by the phrase. The subjectivity of the matter makes it almost impossible to have a reasonable conversation about unless you first have a chat to determine precisely you're each talking about.

Many people think of investment risk as potential exposure to permanent loss of money, but in contrast, practitioners are seeking to define how much volatility their clients are comfortable with. (The answer is actually 'none', by the way.) Unfortunately, for both the askers and the answerers, neither definition is particularly helpful, not to mention the confusion between which is intended.

The first problem is that the vast majority of mainstream investors are not interested in any exposure to permanent loss of capital! So, defining parameters around some acceptable level is as useful as stapling Jell-O to the wall.

The marginally more interesting question sets out to understand what volatility (or return variability) an investor is happy with. That's why we consider volatility to be the measure of investment portfolio risk. Unfortunately, risk and volatility aren't synonymous, since no one minds volatility when it goes up!

Moreover, investors measure their portfolio performance from the beginning of the year, the quarter or the month when the markets are humming along, but when there is a drop, they measure it from the highest point to the lowest.

Also, most investors are subject to emotion. They tend to be more comfortable with volatility, investing more aggressively during stable times, and less willing when financial markets become testy. This causes the same investor to describe her risk tolerance differently during different experiences.

To add fuel to the fire, investors are influenced by their most recent encounters of profits or losses. The stock market correction in September dredged up all kinds of emotion for many folks with the 2008 financial crisis is still fresh in our minds, even though the conditions don't reflect the events that lead to a teetering financial system. It wasn't even remotely close.

In conventional thinking, some have adopted the adage that the older you are, the more conservative your investments should be. They assert that the amount you invest in cash, fixed income (bonds) and guaranteed investments should be higher as you age. Age doesn't determine how your feel about money. You do, and there is no cookie-cutter, age calculation in any formulas. The only truth here is that you're more likely closer to the date when you'll use your money, if at all. To that end, liability matching is more strategic than allocating your portfolio increasingly to investments with maturity dates, just because of the year you were born.

Not surprisingly, most people have an emotional response to losing large amounts of money, even temporarily. If your house assessment was down 30% next January, it would effect your spending habits. So, even though we talk about 'comfort with volatility', when the capital markets drop 10% or more, everyone twists in their seat. Some only hide it better than others.

No one likes permanent loss of capital and no one seeks to have a drop in the value of his or her assets. What we need to understand is if you can sleep at night when your monthly statement value has dropped by some amount. More importantly, will it impact your ability to enjoy your life and meet your personal financial obligations, if this were to occur?

If not, you should reduce exposure to investments tied to the oscillating economy, such as stocks. Other risks, too numerous to explore here, should be avoided entirely. There is no investment compensation for non-economic risk and gambling offers nothing more than random chance.

This information should not be construed as investment advice, nor can it take into account your own specific circumstances. The opinions formulated within this article are based on sources believed to be reliable and may not reflect the opinions of any organizations that I am affiliated with.

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