Emotional Versus Behavioral Risk Tolerance

[Antares]

I've wondered about this issue. Often risk tolerance is defined by what a person would do in a severe market correction. Would he be tempted to sell, locking in losses. Alternatively, people speak of "being able to sleep at night", i.e. how much anxiety does a market selloff cause one? From a financial point of view, anxiety is important because enough of it might cause one to do something foolish, i.e. sell.

In my case, I've been through numerous downturns. I would NEVER sell as the market falls, because I know it would be foolish, and might be financially catastrophic. And yet, I can be prone to feeling pretty anxious and bad as the market falls, despite my rational self-reassurances. My risk tolerance is high, by the behavioral criterion. The anxiety I know I will experience as the market necessarily crashes sometimes is the price I am willing to pay for better long term returns. I don't want the lower returns I would have in buying myself less anxiety. I don't like it, and "tolerance", I suppose, is an ok word because I tolerate it even though it makes me feel a way I do not like feeling.

 

Any thoughts?

[Complete_newbie]

Just like the other thread where "20%" of physicians are literate in personal finance, I will venture a guess: only 20% of people don't have any anxiety in a severe market downturn.

Pareto rule. 60% of the time, it works everytime...

 

On a serious note, isn't this VERY thing the reason index investing works? You want to stay the course to make up for crap years by staying in for the upside later? Same rule for "value" investing (assume people see the value eventually and reward you for buying cheap stocks beforehand).
Grind it out is the name of the game in this style of investing.

[Zaphod]

For those of us that havent been through a downturn, it will be a learning experience. Hopefully all this knowledge and everyone elses experience helps, because no matter what we think we can handle it will be totally different in the moment.

I always like that line, if you're going to panic, do it early. Pretty funny.

[Kamban]

Antares wrote:

In my case, I’ve been through numerous downturns. I would NEVER sell as the market falls, because I know it would be foolish, and might be financially catastrophic. And yet, I can be prone to feeling pretty anxious and bad as the market falls, despite my rational self-reassurances. My risk tolerance is high, by the behavioral criterion. The anxiety I know I will experience as the market necessarily crashes sometimes is the price I am willing to pay for better long term returns. I don’t want the lower returns I would have in buying myself less anxiety. I don’t like it, and “tolerance”, I suppose, is an ok word because I tolerate it even though it makes me feel a way I do not like feeling. Any thoughts?

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The more the number of bear markets and crashes one has the less the anxiety with each subsequent downturn. My first experience with it was the market crash of 1987 when on Black Monday the Dow lost 22 %. Then came the recession of 1990-91, the dot.com bust of 2000 and the bear market of 2007-2009.

By having other source of income I am not dependent of just the stock market returns and hence I neither dell or lose sleep when the market goes South.

[BurnedoutDoc]

I think you have to know your own personality, and if you are married also make sure your spouse is comfortable with the buy and hold strategy.  It is very easy to look at a chart after a big market downturn and recovery and think, what was the big deal?  It is another to live through headlines everyday for weeks to months of how the whole financial world is imploding.  I think my generation is very lucky we went through the great recession early in our careers, the experience will help us get through future, hopefully smaller bear markets.  Also I learned make sure you have 7-10 years in stable assets before you retire!

I love the idea of the bucket method:

http://www.theretirementmanifesto.com/how-to-build-a-retirement-paycheck/

My brain likes to compartmentalize things.  For me, this approach can take away a lot of the emotion.  Instead of looking at my whole portfolio going down in price, I am just thinking about my next 7-10 years of spending that is easily accessible.  Honestly, I think a lot of my long term retirement money in stocks is going to go to the next generation anyway.  We would all love to live until 95 in great health but I think the realist in me says not gonna happen...