Sound Investing Starts with Knowing Your Risk Tolerance
Having a clear understanding of your risk tolerance is one of the most fundamental tenets of investing. Your risk tolerance level serves as the basis for determining how best to allocate your portfolio, while allowing you to sleep at night. Knowing how much risk you can tolerate will help you achieve your goals within your investment horizon without added stress or worry.
WHAT EXACTLY IS RISK TOLERANCE?
At its simplest, your risk tolerance is the amount of risk you are willing and able to assume to achieve your goals and investment objectives. It is the measure of your financial and emotional ability to withstand negative returns on your investments at any given time.
Understanding risk tolerance starts with the premise that the more risk you assume, the greater the return you should expect, and vice versa. For example, suppose you are financially and emotionally able to withstand significant losses in your portfolio value without affecting your ability to achieve your long-term goals. In that case, you could invest more aggressively to potentially achieve long term higher returns. Conversely, if you don’t feel you could tolerate much of a loss in value, you should consider investing more conservatively.
Measuring risk tolerance is a function of multiple factors such as your time horizon for investing, the amount of money you have to invest, your liquidity needs, and your current income. Generally, the greater the amount of each of those factors you have, the more risk you may be able to assume because you have a greater capacity to withstand some downturns and still recover from them.
HOW MUCH TIME DO YOU HAVE?
Time is one of the most critical factors in measuring your risk tolerance. How much time you have to invest before you need access to your money can help determine how much risk you should take. For example, if you’re young with more than 25 years before retirement, you may be able to tolerate more swings in the stock market. If the market falls 20 percent in a year, you have plenty of time for your portfolio to recover.
Older investors with only ten to fifteen years before retirement have less time and fewer market cycles to allow the market to recover, which might dictate a lower exposure to equities. It is also important to remember that retirement is a phase of life that can last a long period of time, over 30 years for some people. While it can be important to maintain a growth position up to and throughout retirement, they may need to add more stable investments to reduce volatility.
UNDERSTANDING THE IMPACT OF RISK ON YOUR CURRENT AND FUTURE WEALTH
The critical question is, considering a stock market decline of 25 percent or more, how much would your financial position be impacted? More specifically, would your current financial position, considering your net worth, income, and time horizon, be sufficient to absorb the loss and still enable you to achieve your goals and investment objectives?
Younger investors have time. Investors who are still working have cash flow. Wealthy investors have assets that can be repositioned. In these situations, a severe stock market decline may not materially affect their ability to achieve their objectives. Even if they had a very large portion of their portfolio in the stock market, they could potentially withstand the loss and go on to generate future returns.
Investors with less time, wealth, or cash flow are likely less able to withstand significant losses and may not be able to take more risks to achieve higher returns. They may need to allocate a larger portion of their portfolio to more stable investments to minimize volatility and risk.
DIG DEEP FOR ANSWERS
To pinpoint your risk tolerance, you need to answer some critical questions. For example, which statement best reflects how you feel about investing in the equity markets?
- I am unwilling to experience any reduction in the value of my investments.
- I can tolerate infrequent, very limited declines (less than 5%) through difficult phases in a stock market cycle.
- I can tolerate limited declines (between 5-10%) through difficult phases in a stock market cycle.
- I can tolerate periods of moderately negative returns (declines of 10-15%) to achieve potentially higher investment returns. I recognize and accept that negative returns could persist for a year and possibly longer.
- I can tolerate periods of significant negative returns (greater than 20%) for the chance to maximize my long-term returns. I accept that negative returns could persist for a year and possibly longer.
Your answers to these and other questions will create a risk profile to determine if you are extremely risk-averse, highly risk tolerant, or somewhere in between. However, it is essential to understand that your risk tolerance level will change based on your personal circumstances or how you perceive the markets. That’s why performing a risk assessment regularly is necessary to ensure your portfolio allocation always reflects your current financial and emotional ability to tolerate risk.
YOUR RISK TOLERANCE LEVEL
Risk tolerance is so important that we begin new client relationships digging deep into your attitudes and feelings toward volatility (among other objectives) so we can gauge how aggressive or conservative your portfolio should be. Of course, as we mentioned above, we also consider other factors, including in your time horizon and long-term goals. But getting to the heart of your feelings about investing is just as critical.