Question of the Day: What Is Your Investing Risk Profile?

Before starting my investment unit with students, I ask to them complete this simple and short Risk Profile Quiz.  One of the fundamental tenets of investing (which I have learned the hard way) is that your investment strategy must match your risk tolerance (or profile).  Invest aggressively in a 100% stock portfolio when you have a low tolerance for risk and watch what happens when the next bear market occurs (a drop of 20%).  You sell at the bottom and then have trouble getting back into the market and miss out when the stock market turns up again.

Having administered this quiz now for a number of years, the results skew towards a low tolerance for risk.  In a low-income community where money can be precious, the idea of risk and the potential for loss by investing in the stock market doesn’t have much allure.  Based on recent news stories (here and here and here), this is not just an issue in low-income community, but rather with young people overall.  Scarred by memories of the Great Recession, they have missed out on the strong bull market which has seen the S&P500 increase close to 200% since it bottomed in March 2009.  As and educator, it is critical to understand your students’ mindset as you consider how to craft your lesson.

So, how do you show a skeptical audience that investing in the stock market can be beneficial in creating wealth?  Here are a few ideas I have used over the years:

  • Compare returns for various types of assets:  cash, bonds and stocks.  This simple chart below shows how returns are impacted by inflation too.  As an example from today, putting money into a savings account earning .05% while inflation is running at 1.5-2.0% means you are LOSING money.  Plug these real (after inflation) returns into a compound interest calculator and assume that you can save $400/month (about 10% of $50,000 salary) for 40 years and see how dramatically your wealth varies based on your investment decisions.  Also,

ar_asset_performance

  • Introduce the concept of dollar cost averaging, in which investors put a set amount into the stock market on a regular basis so that they are buying less shares when prices are high and more shares when prices are low (simple example, if you are investing $400/month, when price is high, say $40/share, you would purchase 10 shares and when price is low, say $20/share, you would be purchasing 20 shares.  This helps counteract common investor behavior of buying high and selling low.  Instead, the dollar cost average is buying more when prices are low.  The other advantage of dollar-cost averaging is to get young investors comfortable as they are growing their portfolio over time.
  • Introduce concept of diversification (investing in variety of assets) which can help reduce but not eliminate risk.  Here is a useful table from Vanguard showing how asset returns and volatility vary based on an assets split between stocks and bonds.

I am always interested in hearing from teachers about what works when they teach investing.  Send along your ideas to tim@nextgenpersonalfinance.org.  Thanks!

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