A turbulent stock market can shake the resolve of even the savviest investor. That’s why it’s crucial that your stated risk tolerance (how much risk you’re logically comfortable with) aligns with your risk composure—your emotional reaction to market movements.
Of course, everyone’s confident when conditions are sunny. “But the pain of a loss is twice as intense as the joy of a gain,” says Certified Financial Planner Brad Klontz, founder of the Financial Psychology Institute.
So how can you figure out during good times how much risk you can handle when things aren’t so flush?
The Trash Can Test
To help a hypothetical downturn feel more tangible, Klontz says, check out your investing account balance and determine how much you’d lose after a 20-percent dip, for example.
Say you start with $5,000, which drops by $1,000. Hold a stack of $1 bills and pretend each one represents $100. Now throw 10 in the trash can. It may seem silly, but as Klontz points out, “using dollars, instead of talking about abstract percentages on a spreadsheet, is as close as someone can get to the experience of losing actual money.”
Of course, you aren't actually losing any money unless you sell. But Klontz wants to see if his clients are able to weather this kind of drop—understanding that the U.S. stock market has recovered from every downturn. Or if they’re tempted to sell.
Investors who’ve lived through downturns tend to be less likely to dramatically shift their asset allocation—or their portfolio’s breakdown of stocks and bonds (which are generally less risky)—compared to less experienced investors, many of whom immediately announce they want to make an adjustment.
Klontz recommends sitting with those uncomfortable feelings before tinkering with your portfolio, so you don’t let a knee-jerk reaction dictate your investing choices. But if you feel like you can’t stay strong and stick to your investment plan during a downturn, he says, you’ve likely overstated your risk tolerance and should revisit your asset allocations.
Considering a more conservative portfolio before a dip can help calm your nerves when it happens—and help you avoid emotional, and potentially costly, reactions, like selling when your investments are down. It’s important to remember, too, that those losses only become real when you sell. Throughout history, the stock market has recovered from every downturn and continued to climb—meaning if you hadn’t sold when the market fell and waited until it rebounded, you’d never actually be throwing those bills in the trash.