Investing doesn't come without any risk, but how much you actually take is a matter of choice. Being aware of just how much risk you generally take requires a whole other level of awareness. While there is no shortage of popular assumptions and basic tools that assess risk tolerance (from gender norms to "How would this make you feel" types of questions), it's not always easy to see yourself as you are -- and how excessive risk-taking could be hurting you.
Here are two key ways to find out if you're a big risk taker, and how to protect yourself from yourself accordingly.
1. You trade. A lot.
If you're always itching to hit buy or sell, this might be you. Of course, how much is "a lot" is a matter of perspective; some people trade every day, and others barely muster once a year.
It depends in part on your objectives, of course. If you have a 401(k) with a 30 year time horizon, trading more than once a year is probably not doing you any favors. On the other hand, if you're a day-trader, you're probably trading pretty much every day (and you probably don't need this article, as we all know that you're pretty risk tolerant).
But no matter what your objectives, trading is almost certainly hurting you.
Why is it so bad? Seemingly invisible transaction fees that add up over time. Nothing is better at eroding performance than trading costs. If you trade a lot, you need to be truly exceptional to justify the cost -- and unfortunately, most of us just don't fall into that category.
The fix: It's easy to say "stop trading so much," but it's quite another to do it. One way to find your motivation is by actually calculating how much you lose each year in transaction costs and taxes.
Another would be to set some limits -- literally. Plan out when you'd want to get out of a position or buy more, and put stop loss and limit orders into place. This removes emotion from the trading equation while still giving you a chance to make the trades that you really want to make.
2. You drive a car with a big engine
What does that have to do with anything?
Norwegian researchers found that entrepreneurs (classic risk-takers, generally speaking) are not only more likely to trade stocks, but they're also more likely to drive fast cars. In other words, they're more likely to be "sensation-seeking".
Sensation-seeking is tied to a desire for new and novel experiences -- you can see where this is going. For a lot of investors, the thrill of the market's ups and downs are a more potent motivator to invest than any lecture on value or dividends could ever be.
Your fast car investing strategy might be great when things are going your way, but it can cause major problems when they aren't. That's because risk takers may also be more likely to have highly concentrated portfolios and to to double-down on their bets, taking matters from bad to worse in a hurry.
The fix: Rather than try to change your personality, embrace it responsibly by creating separate accounts.
For example, if you love the thrill of the roller-coaster world of investing in IPOs, set aside a little pot -- not your entire 401(k) -- exclusively for this purpose. Then set some ground rules (e.g., what happens if the account goes to zero?) and invest to your heart's content, knowing that the bulk of your capital is still going to be there should things not go as planned.
As for the bulk of your capital: diversify, diversify, diversify. It's the kind of advice that gets repeated all the time because it's true: you're almost certain to outperform by minimizing costs and diversifying than by going for the big wins. So take your big pot of money and diversify it.
And then stop trading so much.
