Finding your Risk Tolerance
Alright, so now that you've distinguished the difference between risk capacity and risk tolerance-- how do you actually determine what your risk tolerance is??
It is crucial to understand the risk that your investment choices carry and the potential losses those choices can induce. Investing without understanding your risk tolerance can lead to a total sabotage of your financial success. Quite simply, before making investment choices, you need to understand how much money you are willing to lose.
Let’s refer to your risk tolerance as a “how well do you sleep at night” test. If you are investing properly in a way that is tailored to you, your portfolio should not keep you up at night during normal market events. Risk tolerance numbers are calculated based on the amount of loss an investor can emotionally tolerate.
Recent studies have found that people are twice as averse to losing money as they are keen to making a profit. However, I believe this anxiety is highly influenced by the fact that most people are investing outside of the limits of their risk tolerance.
Investors tend to buy when things are good, sell when they get nervous, end up missing out on investments during the recovery, and only buy back in when the markets “feel safe again". A properly aligned portfolio will allow you to hang in there and weather the storm when markets reach some volatility-- which, of course, is inevitable.
Your risk tolerance indicates how far can a portfolio fall, within a fixed period, before the investor (aka you) will capitulate and sell out. Even though investors should be focused on the long term, most end up reacting to risk in the short term. However, hasty emotional reactions to risk is the number one detriment to long-term financial success.
Historically, investors have used the risk classifications of Aggressive, Moderate or Conservative based only on their age (and this is how Target Date Funds approach risk). This is an objective and antiquated way of assessing risk, and it doesn't give too much guidance about how each risk classification requires you to adjust your portfolio. What does it really mean to be moderate? How do you create a moderate portfolio without guidelines?
***In a recent study*** of risk tolerance by age, the research shows that 52% of 20-29 year olds aren’t aggressive, while 53% of 70-79-year olds aren’t conservative-- which contradicts the traditionally assumed age associations with risk. Traditional risk questionnaires ask investors qualitative questions, but those questions do not focus on the client's true feeling of losing money.
So, what’s the right approach? Investing should begin with establishing your goals for your investments. It is always important to start with the end in mind: we are giving up current enjoyment (spending) of our money to put it away for future use.
Many people “max out” their 401ks because that is what they have always been told is best, and they are making enough money to put the maximum amount away each year. However, a much better approach is to create a financial plan which lays out your end goals and functions to work towards them accordingly.
You should not take more risk than you need to nor take less risk than you are able to.
Of course, goals and savings capabilities can change over time, but you must begin with a clear idea of your risk tolerance at your starting point. Figure out how much you need and/or want in the future and start saving from there.
Using a risk score method, a client is more able to understand the risk in their portfolio by being able to match up their actual investments (all of which will have their own individual score) with their overall risk score.
The Risk Score Method uses risk numbers that range from 1 to 99, with higher numbers indicating higher risk. It determines your willingness to accept risk over a short term, 6-month-period, as opposed to how you feel about loss in general or over a long period of time. This is vital because it is short term decisions (knee jerk reactions) that can derail an investor's success.
A risk score matches an actual investment portfolio to the investor. Below is an investor who has a personal risk score of 70, but their 401k Target Date fund comes in at a score of 79. Their Target Date Fund has them set up to take more risk in their accounts than their own score indicates they are comfortable with! This mismatch of their score to their investment means there is room to make proper adjustments and that gives them a way to reduce the stocks in their investment until their risk score matches the actual investments in their portfolio. Using a traditional questionnaire, they would likely never know that their 401k account has more risk than they are willing to take.
Every investment has a risk score associated with it, and the risk score of a portfolio is the composite of each portfolio. The more stocks in a portfolio the higher the risk score, the more bonds in a portfolio the lower risk score. Creating a portfolio that allows an investor to sleep well at night blends stocks and bonds together to achieve a potential outcome that won’t have the investor freaking out when the market is going down. I like to think of stock investments as black paint and bond investments as white paint: the process of creating a risk aware portfolio blends them together to get a shade of grey that an investor is comfortable with.
Understanding and investing within your risk tolerance is critical to long term financial success. No longer is it necessary to be corralled into generic risk profiles such as conservative, moderate, or aggressive which are very hard to apply to actual investments. A newer, modern approach is to start with the end in mind by understanding how much you will need for retirement and devising a plan to get there. Create a complimentary investment plan to achieve your goals and take the risk score assessment to match your investments to your risk tolerance.