What is your Risk Tolerance?
Building wealth is simple really, it’s mathematical, but it is the emotions that come with finances that is the challenge. Enter the term “Risk Tolerance”, you hear about it all the time but what is it? How can I build up my Risk Tolerance?
Investopedia states “Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand.” But first let’s look at the simple steps to growing wealth.
I will focus on item 1 first and in future articles we will delve into item 2 and 3.
Saving is difficult for everyone, but those that master the habit of saving are well on their way to emotional stability when building wealth. The reason saving or preserving principle is important is we are human and humans are emotional. Savings provide emotional stability to us humans during volatile financial times. Savings is also a way to measure your Risk tolerance.
Side track to the Brain :
The way I understand the brain is there is a lower brain and a higher brain. The lower brain (amygdala) controls the “flight or flight” reaction and is good for possibly saving your life. But it is also the part of the brain that controls your defensive or aggressive behavior. The lower brain gets input faster than the higher brain (cerebral cortex) and gets hit with fear and doubt. The cerebral cortex controls the higher-level thinking skills like logical or analytical thinking.
Think about it this way, if you were worried about making rent or mortgage payment every month how could you be a good investor or speculator? The fear would overcome your higher-level thinking and “fight or flight” responses would not be out of the question. I think this is called “weak hands”, sound familiar?
OK so what, you are talking about saving and risk tolerance!
If you can save and have an emergency fund available, then fear, doubt and volatility would not bother you as much. I hate the term “emergency fund”, I prefer to call it my “emotional stability fund”. And sometimes I think about it as “cash for the crash”.
Building a base that you can feel safe with will provide this emotional stability and help you to think from the cerebral cortex with logic and analytical reasoning. Many of the top companies (Apple, Microsoft, Google, Coca-Cola etc…) have between 6 months to 1 years’ worth of liquid capital (cash), so if something happens, they can still operate with no income. Berkshire Hathaway (Warren Buffet) has $100+ Billion is cash set aside. This stabilizes company executive’s emotions during fluctuations in the market and as a bonus provides opportunities to buy and grow assets in times of market crashes. Now if only we could do this as individuals! Well we can.
It’s not about how much you save; what matters is the habit of saving! Even if you are in debt saving just a dollar is a start. I do suggest not getting into debt and make a plan to pay that debt off, but there are different types of debt (maybe a topic for another time).
Always be saving and always be increasing your savings amount. That is the only way to increase your risk tolerance and start the path to higher-level investing and then later speculating.
Photo by Jeremy Dorrough on Unsplash