How much risk should one take?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.

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.

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bret a nagy

see the W formred in the indices chart' s buy buy buy

August 25 2011 at 1:31 AM Report abuse rate up rate down Reply
dabrownman

Fear, pride and ego are the 3 character attributes that cause failure in all things while there are about a hundred good character attributes required for success.

I will never forget the wild ride up and down the NASDAQ from1,100 to 5,500 in 5 years and back t0 1,000 in two more years. Or ,being a bear in the Dow from 14,000 to 6,650 and then being a bull from 6.650 to 12,000 all in about 2 years just recently. Any fear would not have allowed one to make a large fortune out of a very small one in such a short time - either time.

There is another buying opportunity coming - after the bear is satisfied. Gold will also look good as a long at $1,600 and, after today, that leaves only 150 dollars down to go. If you can't be a lion and a fox in the markets then it is best to realize it and not bet your life in the markets thinking you are right. The pro's will eat you for lunch and crap you out before dinner.

August 24 2011 at 5:59 PM Report abuse rate up rate down Reply
jaantho8

nothing in aol news about the plung in gold prices. i believe the small invester is the who will suffer most and the least ones who can afford it. hedge fund managers makes it both ways,up market and down.short selling,cds,cdo's.trades done in milli-seconds, while you're sleeping at work, or not watching. i saw this happen in the late 70s and 80s. it can happen and will most likely.

August 24 2011 at 2:30 PM Report abuse rate up rate down Reply
Live, from the trail

jamestcap: Oh Please....

Buy stocks now, take that 4 grand out of the 1% savings account, buy anything (CLC) (AIR) (AAPL) and do NOT look for 2 years. Double your dough, guaranteed. Fidelity, set up an acct, it is 7 95 a trade. just do it.

How do you think Warren got Buffeted? Exactly this way, fearlessly buy quality, watch it collapse...Ya still own Caterpillar...Oh...Hey...WhereTF is (CAT) going?

someone has to rebuild this mofay, let it begin with me.

August 24 2011 at 11:42 AM Report abuse rate up rate down Reply
Live, from the trail

I bought BAC yesterday and the day before. I pulled all my money out of there, I brought my friend (89 at the time) to my branch to visit the dough and they treated him like cr$p, so I pulled every dollar and got the manager fired.

Now, at 6 50 a share...in 3 years that is gonna go through the Bank Of America roof.
I always win.

August 24 2011 at 11:31 AM Report abuse rate up rate down Reply
jamestcap

Psychology is certainly important, but other factors also come into play. How large is your investment stash and how does it compare with your goals, in other words how big a margin of safety? Is your job secure, your business in good shape? If all else fails, what other income producing alternatives do you have? Are there any assets you can sell to make up losses? Can an unemployed family member go back to work?

August 24 2011 at 10:04 AM Report abuse +1 rate up rate down Reply
jnett9944

The Dow will drop to 8000 before the end of September.

August 24 2011 at 9:09 AM Report abuse +1 rate up rate down Reply
1 reply to jnett9944's comment
ccstheday

No Way - If you think that jump into the next bubble "Gold".

August 24 2011 at 4:14 PM Report abuse +1 rate up rate down Reply
1 reply to ccstheday's comment
jnett9944

In September I will say to you, I told you so.

August 24 2011 at 4:42 PM Report abuse rate up rate down
martinsportraits

I seriously wouldn't be screwing around too much right now , the whole damn house of cards is going to come tumblin' down very soon , trust me , really ! Things are much worse than the numbers that are fed to you on a daily basis , fabricated to instill confidence ......just watch! .....It was pretty amusing watching S&P fall into an investigation after their legitimate downgrade of US CREDIT...we can't have the stupid American People knowing the truth now can we!

August 23 2011 at 8:51 PM Report abuse +2 rate up rate down Reply
hrrpa47

Brokers make a killing from emotional traders.

August 23 2011 at 4:54 PM Report abuse +3 rate up rate down Reply
ajgorm

Bet on the price of oil going up...

August 23 2011 at 3:18 PM Report abuse -1 rate up rate down Reply