How are Questions of Risk Tolerance Relevant to Online Investing

April 21, 2010

We usually experience fear more powerfully than we do greed. Fear shakes our financial security and scares the hell out of us. At its most powerful, it even jars our sense of personal security in the world. Here’s an example.

In the movie, The Game, Michael Douglas plays a merger and acquisitions big shot. He gets caught in what becomes a very real game that tests his survival strength when his wealth, possessions, identity, and normal insulations from the everyday world are suddenly stripped away from him. He wakes up in a trash dumpster in Mexico, battered and disoriented, with no money.

He is forced to use his wits to get home to San Francisco when he can no longer rely upon the usual support of others he has come to take for granted in his life of luxury. He feels a primal level of fear that he has not experienced since childhood, when he witnessed his father’s suicide by leaping headfirst off a building.

He learns he is capable of surviving hardship and physical danger even when he is not insulated by the trappings of wealth. And, as it turns out, the purpose of the game was to teach him exactly this. He realized a perspective that he may not have been able to gain in any other, less radical way.

My point in using this example is this: If we mistakenly equate the core of our identity with our financial success, when dramatic financial reversals occur, this core identity may be drastically undermined. It feels like the carpet of who we know ourselves to be has been suddenly and violently pulled out from under us. If these things are what we are taught define our identity, who are we without them?

Questions of Risk Tolerance

How are these psychological questions relevant to online investing? In dealing with fear, traders and investors need to know how rattled their sense of identity will be should they lose a portion of their investment capital.

How much loss can you tolerate before having to confront this primal level of fear? Think about times in your life when you had your carpet of personal security pulled out from under you. How did you recover?

If you have never had your limits tested, should a big loss occur, how will you know you can reach deeply enough into yourself to find a sense of identity that transcends your financial status? Or are you just a 30 percent loss of capital away from feeling like a “failure” and ending up in my psychotherapy consulting room?

This is why I argue for knowing your own personality tendencies and seriously considering them in your online investment decision making. If you already know that the terrible anxiety of financial loss would be more than you can mentally and emotionally tolerate, this concern must be weighed heavily in the risks you take.

Your focus needs to be on large-cap, stable companies that are traded in heavy volume and are less likely to test you beyond your tolerance level. These companies will minimize your risk but most likely will minimize possible reward. Of course, if you happen to choose large technology companies, your risk may still be unacceptably high. For those who do not like to monitor their holdings closely, mutual funds are still the best bet.

To respect your own personality type, it is best for those who want to avoid this anxiety to err on the conservative side. You must let mild anxiety and caution stay in the foreground in investment decision making. And you must keep in control of greed, remembering that you would always prefer to be safe than sorry.

But let us now focus on fear as it is experienced in its most common, garden-variety forms for the investor, not just at its identity-disrupting extreme.