August 15, 2020
Risk tolerance is a fascinating subject, especially for those with a keen interest in psychology and human behavior.
Our tolerance for risk is high when we are optimistic that we’ll be successful. For example, a high level of risk tolerance is found among motorcycle racers and Everest climbers. High levels of risk tolerance in love are found in those who run off to Vegas to get married a month after they meet. When it comes to risk tolerance and your investment portfolio, we don’t recommend “going with your gut” as you might with personal relationships and hobbies.
Figuratively and literally, it pays to team up with unbiased financial professionals to understand the impact that your level of risk tolerance has on your investment portfolio and your ‘big picture’ financial future. Risk tolerance impacts every aspect of your investment strategy from your portfolio’s asset allocation and asset location, to your investment goals and time horizon. Understanding your risk tolerance will make a positive impact on the structure and maintenance of your portfolio. Ready to see how? Let’s dive in.
Risk tolerance defined
Your risk tolerance can be described as your overall propensity for market risk and its periodic fluctuations. Risk tolerance is also likened to your overall comfort level with risk and reward as it pertains to your investments. It is usually influenced by your age, past experiences with investing, advice from parents or others, your current net worth and income, and your personality.
Your risk capacity (that is, the risk of placing a big chunk of your investment portfolio in the stock market) is your actual ability to engage in the level of risk you want. It is a mathematical equation that measures the amount of risk you can afford to take without affecting your financial goals.
So risk tolerance and risk capacity are complementary ideas that help shape your investment plan. While you might have a high-risk tolerance, other external factors like your age or investable assets, might not provide the capacity to engage in such a risk. The inverse can also be true. Someone who is risk-averse could miss out on many important wealth-building opportunities by not capitalizing on their risk capacity.
Our primary goal when getting acquainted with new clients is to assess your unique level of risk tolerance and risk capacity to create a financial plan that reflects your goals both now and in the future. Equally important are regular check-ins with you and your portfolio so we can adapt it to your evolving goals and/or life circumstances.
Let’s look at a couple of extreme examples of risk tolerance. Someone with a high-risk portfolio might have 90-100% invested in equities (different companies of various sizes and geographical locations). On the other extreme, a low-risk portfolio might have 80% in fixed income instruments and 20% in large blue-chip companies.
As you read both examples, you’re likely reacting with your own inclination for risk by approving or disapproving of one of the two extremes. When we feel comfortable in our understanding of your financial objectives and risk tolerance, we can talk about how to best implement those ideas into your plan. Read on to discover how we effectively evaluate and manage risk in your portfolio.
Understanding your unique risk profile
Your risk preferences are an important part of your investment planning. We start by having clients complete our risk tolerance questionnaire which provides us with a risk baseline to guide further conversations and planning decisions. By engaging in open, honest discussions about your risk preferences, we can create an investment plan that not only feels right to you but also helps you reach your goals.
The questionnaire uncovers details about your risk tolerance and your overall attitudes and beliefs about the stock market. It also helps answer questions around your general comfort level with risk in the context of your investments.
It’s our goal to ensure that you fully understand the intersection between risk tolerance and risk capacity. Our strategy sessions go in-depth about the utility in having a well-managed investment portfolio that helps you achieve your goals.
Balancing risk and reward to achieve your financial goals
The difference between risk tolerance and risk capacity pertains to how much risk you actually need to (and can) assume to reach the specific financial goals you set. As you can imagine, it’s a balancing act that requires regular analysis, reflection, and often rebalancing to remain aligned with your future goals.
Let’s look at an example. Our imaginary client Greg Smith is a 70-year old divorced man who’s just finishing his career and has a portfolio of $500,000. He comes to us to help manage his portfolio so that it will last for 20 more years. In the past, he took some big risks on his own and lost $100,000 in a bad investment move. Ever since he’s been skittish and has played it safe because his risk tolerance was reduced after his financial loss.
Because of his history and relatively low size of his portfolio for his age, he falls into the camp of those with low-risk tolerance but would likely benefit from increasing their risk to meet their longevity goals. In other words, by playing it “less safe” he is much more likely to realize the higher returns that will sustain him into his nineties.
On the other end of the spectrum, take someone like Jessica Johnson, a 65-year-old with over $1.5 million in assets and only 5% in liquid funds. She has a high-risk tolerance and a sizable portfolio that meets her needs and projected gains, but she doesn’t have much of a safety net. To help, she could redirect a percentage of her funds into ‘safer’ investments to offset that risk.
Why risk tolerance impacts you
Risk tolerance is a crucial piece of your investment plan. It helps guide your asset allocation and other market exposure choices.
Wherever we find you on the continuum of tolerance and capacity, we’ll guide you in the direction that’s most likely to help you reach your financial goals. Your risk levels will adapt as you move into different phases of your life. Your advisor will adjust your plan as needed so that it adheres to your risk tolerance at each of those stages.
We hold honest and frank communication at the core of our practice. At the end of the day, we’ll have the best success together as a team when we understand your propensity for risk, your goals, current financial picture, and your past experiences (positive and negative) with the stock market. We look forward to the opportunity to dive deep with you. Set up a call with our team today.