How Much Risk Should You Take in Your Investments?

Determining your risk tolerance before you invest is a lot like choosing a delivery plan for the birth of your child. When the contractions start, even the best-laid plans can go right out the window.

Psychologists call it the "hot-cold empathy gap": Investors gauge their appetite for risk in a "cold" or neutral state, and then test it out in a "hot" state, when they're angry or fearful. But the truth is, it's impossible to predict how you will feel watching a chunk of your hard-earned savings evaporate until it actually goes "poof."

"We call it the illusion of courage," says George Loewenstein, professor of economics and psychology at Carnegie Mellon University. "When the moment of truth is far away, you're not afraid and not in touch with the fear you experience when the moment of truth arrives. So people get surprised by their own panicked reaction."

Loewenstein has tested the concept extensively. In one experiment, he offered money to students who committed to perform a dance or song in public a week later. When the big day arrived, many reneged. Another group, shown a scary film before the offer was made, was less likely to agree to perform because they were more in touch with their fear, Loewenstein found.

Moreover, when the senses are engulfed by fear, "the human mind is pretty good at finding reasons to justify emotion-driven action -- 'I never anticipated this world economic situation would occur when I made decision to hold firm,'" Loewenstein explains. "That's the fear finding rational justification."

Emotions About Money Rooted in Our Childhoods

Surveys suggest most investors are holding firm: Two-thirds of those surveyed by Decision Research from Aug. 9 to Aug. 15 planned no changes to their stocks and mutual funds over the next 12 months. That kind of stoicism comes from having a strong handle on your goals, knowing when you'll need the money, and having a strategy for how much you'd like it to grow.

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But if you're among the one-third who can't stomach the market's recent fluctuations, it means you're in touch with your fear -- making this an ideal time to formally retest your appetite for risk. There are a variety of questionnaires out there to help you determine your risk tolerance. You can find a few at Fidelity; Vanguard; Charles Schwab; and Rutgers University.

Some financial planners go beyond simple questionnaires and aim to identify people's deeper emotions about money. Diana DeFrate, a CPA and certified financial planner with DeFrate & Paavola Wealth Management in New York, gives clients an additional survey asking about the role money played in their families when they were growing up.

"They talk about some of their earliest memories, what their mom and dad taught them about money, and through that you learn where the fear buttons are," DeFrate says. "Coupled with the risk tolerance questionnaire, it helps us understand how much risk this person can take." A childhood in which money comes to symbolize conflict, deprivation, hostility or control can skew adult decision-making, and ultimately make a bigger mess of one's investments than the stock market.

If you review your risk tolerance and feel too exposed to the market, don't immediately lock in losses with emotional trading. "Tweak your asset allocation over time, but don't do it in the height of the craziness," DeFrate suggests. She worked with clients spooked by the market's tumble in 2008-2009 to set policies for the transition -- i.e., agreeing to move a 60/40 stocks-to-bonds allocation to 50-50 when the Dow moved back to 10,000 and stayed there for a month. Just understand that over the long-term, taking less risk will likely mean lower returns -- and that has to be made up with additional savings toward your goals. (For more on rebalancing, see this piece at Smart Money.)

In my own portfolio, I'm holding on tight -- something I did this summer when my kids convinced me to ride the Top Thrill Dragster at Cedar Point amusement park in Ohio. The world's tallest and fastest roller coaster when it opened, the Dragster launches riders from 0 to 120 mph in four seconds, rocketing upward and then plummeting 420 feet. The experience was uncannily similar to watching the S&P 500 lose more than 16% of its value over the last four weeks. Except the Dragster was over in 17 seconds -- this latest ride will be a whole lot longer.