The following is a guest post by Deanna from MsFiology.com.
Recovery from my addiction has been one of my greatest teachers in life. I never dreamt that by falling so hard, I’d find me. Furthermore, by overcoming my addiction, I’ve discovered all of the things which formerly eluded me:
- Deeper relationships
- Growth mindset
- Peace of mind
- Financial peace
- Deanna 2.0
Becoming An Investor
I’m finally an investor now. That gives me excitement to just write those words because that has not always been the case. I found myself deep in the throes of addiction and abuse in my 30’s. That doesn’t just happen to a person; there is always a story behind that.
Fortunately, I hit a hard bottom and was able to get sober and slowly turn my life around. My recovery has been a long and winding road as I needed to get to the root of things and those roots go deep.
As I got healthier, I eventually wanted to take control of my finances. Digging my way out of debt was a whole other journey that taught me –
- Happiness is not in stuff
So, when I learned about the concept of financial independence, I had already proven to myself that I could do hard things. I set my sites on this lofty goal and starting growing my wealth snowball.
Understanding My Risk Tolerance
I know that I’m late to this investment game. I was 45 when all of my debt was paid off and I could start maxing out my tax-advantaged accounts. I’m now mostly invested in equities.
I chose my index funds, set up automatic transfers, and mostly forget it. I’m in it for the long haul and anticipate hitting financial independence in about 14 years.
When I hear news of the market going down, I buy more because I’m in it for the long haul. This got me thinking of how one can actually calculate their risk tolerance.
In all things, there is a risk and potentially a reward. I’ve come up with some questions to ask yourself when faced with a crucial decision.
A Risk I Am Not Willing to Take
It was August of 2009 when I walked away from an abusive relationship and quit drugs. I still drank on a few occasions as I was trying to wrap my head around the concept of never taking another drink again.
But I realized I was skating on thin ice by even taking small sips of alcohol. Ultimately, I decided the risk wasn’t worth it. I haven’t found it necessary to put a mood- or mind-altering substance into my body since February 1st of 2010.
Keep in mind that in my younger years before I was introduced to drugs, I drank…a lot.
I recognized that drinking and drugging was just a symptom for me. There were bigger issues at play and an unreconciled past to contend with. I drank or drug to be comfortable in my own skin.
Behind this insecure little girl who believed a great many false things about herself was a woman with great abilities vying to get out. In order to unleash the woman, I had to reconcile with the little girl. And in order to deal with the little girl, I needed to put down the crutch – drugs & alcohol.
A Risk I Am Willing to Take
I set myself out on a journey to uncover the lies I had believed about myself since I was a little girl. Furthermore, I identified where the lies came in which essentially stemmed back to my relationship (or lack thereof) with my father.
The tough questions came next –
- Was I able to forgive?
- Could I learn to believe new things about myself?
- Could I apologize to my Dad for my stuff without expectations of his response?
Those were some hard questions I faced but I wanted to stay sober more than anything. Moreover, I didn’t just want to stay sober, I wanted to heal, forgive, and find a new life and mindset.
I wanted to become the woman I was meant to be and that meant I had to face these demons. I was willing to take this risk because the reward was great.
Conversely, the risk of not doing this work was bad. I knew if I couldn’t deal with these resentments I may turn to drinking/drugging again. Before I got sober, I was on the verge of permanent insanity or death. That is about as bad a risk as any.
The risk of facing the demons of my past was far less of a risk than the risk of falling back into addiction.
Some Risks Are Better Left Alone
I’ve done all this work in my recovery and made amends with every person I’ve had any type of resentment against. Furthermore, I identified the typical role I’d play in most relationships and found it was ugly and so I learned to be a different person.
One might ask me then, why can’t I take a drink today? People ponder that if I’ve truly healed then perhaps drinking won’t be a crutch for me anymore. After all, I got to the heart of my issues and discovered why I was looking to escape in the first place. Furthermore, I uncovered why I was attracted to unhealthy relationships with men. Lastly, my father & I have healed our relationship and really quite enjoy each other now. So why can’t I take a drink?
My response is that I know my risk tolerance, and that’s a risk I’m not willing to take. There’s too much uncertainty surrounding alcoholism/addiction for me to ever think I’d test those waters again.
When there is an addiction to something there is an underlying issue. One needs to get to that issue to stay sober. However, my concern is that a drink could trigger something in me and the ability to only have one or two would be thrown out the window.
I’m 100%, okay saying I’ll never have another drink because the risk is too great. I’ve got too much to lose.
Figuring Out Risk Tolerance
Here are the questions I’ve formulated in figuring out your risk tolerance on any situation, be it financial or otherwise.
- What do you risk if you do the thing in question?
- And what do you have to gain by doing the thing in question?
- Is the potential reward worth the risk?
Now consider not taking action:
- What is the risk of not doing the thing in question?
- And is there any reward by not doing it?
Finally, weigh the two:
- Which risk is worse?
- And which reward has the bigger payout?
These were the questions I went through in thinking about what risk I was willing to live with in recovery. The same can be true of our investing life. Remember this is a very personal thing.
Transpose That To Finances
Now let’s translate this little experiment to my financial investments. Today, I’ve got a six-month emergency fund in online savings account so no risk there.
Additionally, I’ve got enough money saved to replace my old car when it dies also in an online savings account so also no risk there. I’ve got no debt.
My career is doing well and I see my income only going upwards. My investment accounts are set on automatic and so I’ll just keep pumping money in them and don’t plan on touching them for another 10+ years.
I invest in low-cost index funds and my current asset allocation is 27% cash/6.7% bonds/66.3% equities. The reason I’m so heavily weighted in cash currently is A) I’ve only been investing for a year and B) I plan to buy a car with cash within a year or two.
Sure, I will lose money if the stock market crashes, but I’m not relying on that money today. Even if I lose my job, I’m confident I will be able to find another one with my skill stack and I can also explore entrepreneurship. With low monthly expenses, I’m not worried.
What is the risk if I don’t invest in equities? I risk missing out on compound growth. I’m not willing to take the risk of missing out on that growth.
Let’s Put It To The SEER Test
Financial Samurai had a great podcast & article on quantifying your risk tolerance. Sam calls it the Financial SEER which stands for Financial Samurai Equity Exposure Rule. Sam has two calculations:
- Risk Tolerance = (public equity exposure x expected percentage bear market decline)/monthly gross income
- Maximum Recommended Equity Exposure = (monthly salary x risk tolerance multiple)/expected percentage decline
- Risk Tolerance = ($55,423 x 35%)/ $6,000 = 3.23. According to Sam, this tells me I’m only exposing 3.23 months of gross income to make back losses from a potential 35% bear market.
- Maximum Recommended Equity Exposure = ($6,000 x 18)/ 35% = $308,571. Sam recommends not to risk more than 18 months’ worth of gross salary; hence, the 18 for the risk tolerance multiple. With my current salary, the most I should risk is $108,000 loss on a $308,571 pure equity portfolio.
What I learned from this exercise is that I can afford to have more equity risk exposure and will keep pumping money into my investments. As I’m new to investing, I’ve still got a good ways to go.
The one thing I can get better at is diversifying my investments into real estate and a business.
I’m currently working on growing my online business model. I’m not yet ready to jump into real estate but plan to within the next five years. Once I have substantial investments in all three, I’ll feel even more sure-footed in my investments.
Now that I’m living with intentionality, I view the risk and reward of most situations. By taking action, I ask myself whether I can stomach the risk to reap the potential reward. If the answer is no, I still need to consider the risk of no action.
If I don’t take action and miss out on the potential reward, I ask myself whether I’ll be able to live with the lack of reward. The key is to weigh all the risks and determine the one that is most tolerable and then proceed in that direction.
Not taking any risks really could be the biggest risk of all. What if I chose not to go down the road of reconciling with my past? Maybe I’d be able to maintain my sobriety. But I’d be missing out on so much of the richness I’ve found from doing this work.
Calculating risk is a very personal matter so be sure to go through the series of questions for yourself and your finances. Develop the habit of doing this in all major situations and investments and you’ll be on the road to growth and purpose.