composure and risk tolerance

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This morning I found this article. I think it's worth reading


Tune in, chill out

Keeping your composure is the true test of your risk tolerance

By Jonathan Burton, MarketWatch

NEW YORK (MarketWatch) -- Warren Buffett became rich and famous because of one deceptively simple investment rule: "Be fearful when others are greedy, and be greedy when others are fearful."



By "others," he means us.


We may think we know ourselves as investors. We dutifully complete questionnaires that purport to show whether we're daredevils or doormats. We seek counsel from advisers and are wary of tips from relatives and friends. And we're convinced that when bad things happen, we'll make the right, reasoned calls to protect our hard-earned wealth.
What kind of investor are you?

Greg Davies, who heads the behavioral-finance unit at Barclays Wealth, has identified several types of financial personalities based on risk-handling and decision-making abilities. MarketWatch's Jonathan Burton is put to the test.




But all that really gives us is a broad and inexact measure of our risk tolerance, how much volatility -- a smooth ride down Wall Street or something more exciting -- we can stomach in our investment portfolios over time.



"We overestimate our abilities," said Dan Ariely, an economics professor at Duke University and author of "Predictably Irrational," which examines investor decision making. "People say they're willing to lose 20%, then they lose 2% and they panic.



"Nobody really knows what they can tolerate until they're in that situation," he added. "I could call you up and say you just lost 10% -- now you would really feel it."


A more meaningful indicator is composure -- your short-term, emotional reactions to unpredictable and uncertain events, such as the market's ugly sell-off on Friday.



How will you handle yourself in the heat of battle? Far too many investors discovered in 2008 and early this year that losing money in quick, sharp cuts was more than they could bear. Those thoughtful risk-tolerance quizzes got shredded when stocks went into free fall. Panicked investors sold what they could, often at any price.
Buffetts among us

Had they anticipated the worst, investors could have put less money in stocks and lowered their risk exposure. A less-volatile portfolio might have kept them on the field when the market rebounded.
Instead, many former shareholders are now on the sidelines -- with the Standard & Poor's 500-stock index up more than 50% since March. They're skeptical, fearful and unsure if, when, or how to get back in.


There's a good reason why there aren't more Buffetts among us: Buffett is not only more risk tolerant, he's more composed.



When the shooting starts and money is on the line, Buffett comes across as cool and unemotional. And he fires back. Think Clint Eastwood with a calculator.
"To the degree you're able to anticipate how you feel, you're going to be composed," said Donald MacGregor of MacGregor-Bates Inc., a Eugene, Ore., firm that researches consumer judgment and decision-making.



"You're not going to have a knee-jerk reaction."


"Composure is about risk attitude -- the emotional responses to my portfolio day-to-day, month-to-month," added Greg Davies, head of behavioral analytics at Barclays Wealth, a unit of Barclays Plc., who researches investor behavior. "Understand where you fit and build your investment program around that."
Truth time

Standard risk-tolerance questionnaires usually don't say much about composure. Often they ask for responses on a scale of 1 to 10, but there are too many variables for any accurate reading. The same holds for questionnaires that assume investment knowledge, such as whether you're more comfortable in high-yield bonds or dividend-paying stocks.


"We've never used risk tolerance questionnaires because we've never found them meaningful," said Ross Levin, a financial adviser in Edina, Minn. "In the middle of a crisis, that intellectual exercise doesn't help you emotionally."



Barclays Wealth created a survey that factors composure into its questions about risk tolerance, asking people to rate their answers on a scale from "strongly agree" to "strongly disagree."



And some of the questions are not necessarily about investing. For example: "I am not easily bothered by things," "I get stressed easily" and "Uncertainty makes me uneasy, anxious or stressed."



"Higher composure is better for the average investor," Davies said. "If you don't have the knowledge and expertise to be making good short-term decisions, you should probably stay away from them. Higher composure helps. Doing less rather than more is almost always a good idea."
How can you build your composure?

First, commit to an investment policy with a long-term or big-picture focus that recognizes there will be major pitfalls along the way. This is your battle plan.
"An investment policy statement helps govern decision-making in times of stress," said Michael Pompian, a New Jersey investment adviser. "


In March 2009 it looked like the world was melting down and people's emotions started to take over. All they could think about was the negative. An emotional intelligence is what's really critical during times when there's a desire to withdraw from a structured investment process."





The most effective policy statement lays out objectives. These include return goals -- how much money you'd like to make -- and the potential obstacles to that happy outcome, Pompian said.
In this way, you get a sense of how emotions dictate your actions. You better understand your "loss tolerance," Pompian added. "Nobody is concerned with upside risk; it's downside risk."



If you are someone with low composure, you'll need rules against snap decisions. Draw up the list in calmer moments, not during the storm, "so that when the hurricane hits there will be no doubt as to what the intentions are," Pompian said.





Second, divide your wealth into different mental accounts with varying degrees of risk.
Levin, the Minnesota financial adviser, suggests three "buckets": one for income, one for inflation-protection, and a "legacy bucket" for heirs and charity.
"You take more risk in the legacy bucket, are balanced in the inflation bucket, and income-oriented in the income bucket," Levin said.



Also, don't become overly invested in any one type of asset or sector. For instance, you could have money in value stocks, real estate investment trusts and financial services stocks and say you're diversified. In fact, noted John Nersesian, a managing director at Nuveen Investments, you'd be heavily exposed to the credit markets.



"Investors should not be diversifying asset classes; they should be diversifying risk," he said.
Finally, don't just do something -- sit there. Be reflective, not reflexive. If you are investing long-term, stick to it. Resist the temptation to trade.



As humans, we are programmed to avoid pain. As investors, it's been proven that the pain of a financial loss is more acute than the pleasure of a monetary gain. In an effort to eradicate that pain, people act irrationally and emotionally. Try to keep your head. If you've preplanned for unfortunate events, you won't be so shocked and feel compelled to act.



"The question," said Ariely, the Duke professor, "is which one of your two selves is the correct one" -- emotional or rational? "People think it's not the emotional one. But the fact is that we live with our emotions as well."
 
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