How much loss can you actually take
How much risk suits you has two sides: what you can afford financially and what your nerves can take. The smaller of the two limits always applies.
Learning objective: After this lesson you can judge how much loss you can really handle, financially and emotionally.
As long as prices are rising, everyone feels brave. So the honest question is: how big a drop can you stand without selling?
Counting in euros
Think in euros, not percent. If Anna has €20,000 in her portfolio, a 40 percent drop, which happens in markets time and again, means it shows only €12,000 for a while. And maybe for two years.
When the number keeps you up
If that number keeps you awake, your share of volatile investments is too high. That says nothing about your character. It's useful information about yourself.
Two sides of tolerance
There are two sides. One is financial: what happens to your everyday life if the money shrinks? The other is how you feel: how do you cope with it? Both count, and the lower limit decides.
Professionals distinguish between risk capacity and risk tolerance. Capacity can be measured: income, assets, obligations and time frame. Tolerance is how you feel about it. The smaller value is what matters, because high capacity is no use if you sell during the drop anyway.
Limits from real drawdowns
To find your own limit, real declines from the past help more than questionnaires. Broad stock markets have fallen 40 to 55 percent several times and taken years to recover, individual cryptocurrencies far more. Choose your equity share so that such a decline only pushes your total wealth down as far as you can stand.
The mistake in good times
A common mistake is setting your limit during a good market phase. How much risk people think they can handle depends heavily on what has happened in the market lately. So write your limit down while things are calm, and read that note in a crisis instead of deciding afresh.
Summary
- Think of declines in euros, not percent.
- The smaller number applies: what you can afford and what you can stand.
- Write your limit down while things are calm.
Did you get it?
What's the difference between risk capacity and risk tolerance?
Capacity depends on income, assets and time. Tolerance is what your nerves can take. The lower value applies.
Why is a risk test during good market times unreliable?
Because the answer depends heavily on what has happened in the market lately.
What declines should you expect in broad stock markets?
In the past there were several declines of 40 to 55 percent that took years to recover.
Check your understanding
Your task
Take an account of $15,000 and calculate how many dollars remain after a 40 percent drop. Test the same with your own numbers in the crash test. Write down the dollar amount at which you honestly would sell.
Sources and further reading
- Robert Shiller's freely available historical market data (Yale) go back to 1871 and document the roughly 40 to 55 percent declines cited in broad U.S. stock markets. View source ↗
Related
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- Expensive debt firstStage 0
- Reading a balance sheetStage 4
- Matching questions for this stageQuestions