How to Determine Your True Risk Tolerance – and What That Really Means
Usually, finding profitable investments is the main thrust behind investing. Depending on your financial goal, your mix of individual stocks, bonds and alternative investments are critical to your financial success.
But risk is often underestimated by many investors, who can be rudely awakened to the full meaning of risk during a market downturn or recession. Equally significant is the importance of rebalancing portfolio levels when your life – and your risk tolerance – changes.
Having a deeper understanding of risk as it relates to your portfolio will keep you and your advisor on the same page when picking your investments. And it can give you the most efficient path forward toward your financial goals.
A Quick Primer on Risk
To start, let’s define risk.
Risk is the chance that an investment’s actual outcome will differ from its expected outcome. Despite its stigma, risk isn’t good or bad. While taking on too much risk can lead to heavy financial losses, too little risk means your potential investment gains will be miniscule and you may not be able to reach your goals.
Becoming familiar with investment risk and your own comfort level with investment risk will make your conversations with your advisor much more effective.
Take a Look Behind the Curtain of Risk
Model portfolios are often shown to investors as pie charts, ranging from conservative to aggressive. But this isn’t enough to determine your true risk tolerance.
A full financial planning conversation is a better way to determine risk, as it introduces a number of important concepts to help investors.
So, what’s the right amount of risk to reach your goals?
Conversations with your financial advisor should involve a multitude of questions. At Scarborough Capital Management, we discuss our clients’ specific financial goals first, and then our ideas to work toward those goals. Some goals require more future growth than others and therefore, strongly determine the risk level of one’s portfolio. This is an example of risk capacity, the level of risk “required” to address a particular goal. This is different than risk tolerance.
For example, an investor looking to aggressively catch-up and reach their retirement goal in 10 to 12 years may need portfolio returns of 5 to 10 percent annually, plus monthly savings. A portfolio that can achieve these returns will likely require at least a moderate amount of risk.
On the other hand, an investor who needs to preserve a certain sum of money, prioritizing safety over growth, will consider investments centered on lower volatility and lower risk (and return potential).
Remember, the risk capacity of your portfolio is directly correlated with your financial goals and time horizon. The more returns you need, the more potential risk or market fluctuations you may need to take on, if you can tolerate it.
That’s where the importance of rebalancing your portfolio comes in. When life changes your goals, your risk may change and, therefore, your portfolio may need to change. It’s wise to review your portfolio with your financial advisor at least once a year.
What’s Your Risk Tolerance?
Once you’ve determined the risk-return relationship of your financial goals, you can choose from various investments that can potentially generate these returns. This stage of your portfolio planning requires you to evaluate your ability to tolerate the potentially volatile movements of a particular investment or strategy.
Most investors would be thrilled with a particular stock returning 15 percent in one year. But some may prematurely sell their investments if the stock endured a 10 to 20 percent decline, effectively guaranteeing a loss.
Risk tolerance is different for each investor, and can be complex. As important as it is that investors understand the risks of certain investments, financial advisors must also become familiar with their client’s unique risk fingerprint by having a thorough conversation first. A quick online test doesn’t usually do the trick.
Properly Discuss Risk with your Financial Advisor
When discussing portfolio risk and risk management with your financial advisor, be straightforward and have it explained to you in actual dollars.
Additionally, it’s helpful to have a basic understanding of past market downturns This can help you keep an objective and realistic perspective about investing, not chasing get-rich-quick strategies or following “hot” investments. Proper investing requires a full financial plan, a goal-oriented and diversified portfolio, and the proper understanding of the market risks involved.
Ask the Right Questions
What’s a 5, 10 or even 15 percent loss in actual dollars? Percentages may be easy to understand for some, but explaining that an aggressive portfolio can lose $8,000 to $9,000 in a year can paint a clear, objective picture for investors. If you require strong returns for a particular goal, are you comfortable with this amount of risk in your portfolio? Keep in mind that risk and returns are two sides of the same coin.
Depending on economic activity, risk levels can change quickly. Bond portfolios are typically seen as a conservative choice, but, if the Federal Reserve raises interest rates two or three times in one year (as seen in 2017), then bond portfolios will lose value, and the overall outlook on the bond market changes. Are you aware of some of the specific economic risks of your portfolio? How will your portfolio’s diversification soften the blow of volatility?
The purpose of investing is to reach your financial goals and feel financially secure. But that potential is eliminated if excessive portfolio fluctuations and volatile market swings make you feel insecure.
Dispel Fallacies and Avoid Common Pitfalls
Risk isn’t always objective, even in everyday life.
For example, despite the number of fatal lightning strikes greatly surpassing shark attacks, the average American fears shark attacks more than being struck by lightning. Similarly, an investor’s response to market uncertainty can be influenced by popular trends and not based on facts. Past market declines exemplify this.
Learn from Recent Crashes
During the dot com bubble of the late-1990s, many investors witnessed how Internet-based stocks surged one year, only to see their investments decimated after the bubble burst. During this time, investors experienced heavy losses. Many investors incorrectly perceived certain stocks to be low-risk, basing their opinions solely on popularity and return potential.
Another moment in history that may still hit close to home for investors is the housing bubble that led to the Great Recession in 2008. Investors took advantage of lenient lending practices and swarmed the housing market with the belief that “housing prices will always go up.”
Many believed that investing in housing offered lower risk and was an easy way to achieve fast profits. Unfortunately, the housing crisis lost $7 trillion in equity, and thousands lost their homes as foreclosures quadrupled.
Bottom line: Before you follow the crowd on a popular investment, consult with your financial advisor.
Your Financial Advisor is your Greatest Ally in Managing Risk
Managing the numerous intricacies of your investing isn’t always easy. Assessing your financial needs and picking investments can be difficult enough, and predicting risk and risk tolerance can be even more complicated. A more prudent action in your financial planning and risk management is to let your financial advisor do the heavy lifting.
Your financial advisor will be able to guide you through an investing season and create a portfolio that fits your financial needs, risk tolerance and planning goals together. Over time, your financial advisor will also be able to easily adjust your portfolio with respect to risk, strategy or more. The importance of rebalancing portfolio risk is not to be taken lightly.
If you’re looking for a financial advisor in the Annapolis area, contact Scarborough Capital Management to see how we can help.