What’s your risk tolerance? How do you indentify it? Both are important questions that investors spend little time thinking about at first. They’re also abstract questions thanks to the convoluted definitions of risk.

Daniel Kahneman suggests a better way to frame the question. Rather than risk tolerance, you should ask: what’s your loss tolerance? It makes you think about protecting your money. How much loss can you endure before you reach the point where emotions push you to change your mind and change your portfolio?

That breaking point is important because it’s usually where mistakes are made like buying high and selling low. Changing your portfolio every time emotions surface leads to worse results.

By reframing the question, Kahneman forces you to think in terms of actual dollars. Lost dollars can be quickly equated to missed goals and dreams — less money for college, a canceled vacation, a postponed retirement — that make you nauseous.

So how much of your net worth do you want to keep safe versus how much are you willing to lose outright? The goal is to find that breaking point so you can build a portfolio that minimizes regret, limits how often you change your portfolio, and keeps you invested for the long run.

Kahneman went on to explain the importance of minimizing regret and how it translates to portfolio construction. Here’s what he said: Continue Reading…