Determining Your Risk Tolerance
Perhaps the most important factor in formulating your investment plan is your risk tolerance; that is, the amount of risk you’re willing to assume in order to achieve your most important objectives. More precisely, your risk tolerance is based on the your financial and emotional ability to withstand negative returns on your investment portfolio.
Before embarking on any investment strategy it is important to know your risk tolerance to ensure that you select the right kind of investments and you are able to set clear objectives. More importantly, when your investments are aligned with the proper risk-reward continuum, you’re assured of many more restful nights. So, how do you go about determining your risk tolerance?
Look at Your Time Horizon
The most important determinant is time; that is, how much time you have before you will need to access the money being invested. Younger people, those with more than 30 years before retirement, are more able to withstand the swings and the cycles of the stock market because of the tendency for the market to increase over time. When the stock market declines by 20% or more in one year, as it has a few times over the last couple of decades, a younger investor has the time to allow the market to recoup its losses and forge ahead for a couple of years. Therefore, they could take a more aggressive posture towards investing by increasing their exposure to stocks.
An older investor with less than 15 years before retirement has less time and, therefore, fewer opportunities for the market to recover from multiple down years or extreme volatility. While it is still important for investors in the pre-retirement phase of life to maintain a growth orientation on their investments, their portfolios need to be stabilized with investments that produce less volatile or more predictable returns.
The Impact on Your Current Financial Situation
Using the same stock market decline of 20%, you need to simply ask yourself, if I lost 20% of my wealth this year, would it materially change my financial position? The real question is whether your current financial position, based on the amount of wealth you have, your income, and your time horizon, could absorb the loss and still allow you to achieve your financial goals. A younger investor has time. A high earning investor has excess cash flow to invest. A high net worth investor has assets that can be rebalanced. Their answer to the question might be that such a loss would not materially affect their financial position. If all of their money was invested in the stock market, they may be able to withstand the loss and live to see future positive returns.
For an older investor, or one with minimal assets or cash flow capacity, the impact could be more significant. If they could not withstand the 20% loss, their investment portfolio would need to consist of investments with limited downside risk and limited upside return potential, such as bonds or fixed yield investments. By allocating a larger percentage of their portfolio to more stable investments, they are not likely to experience such a big decline in the overall value of their portfolio.
Digging Deeper for Answers
Then you need to ask yourself some questions to gauge your general attitude about risk. For instance, when you make decision about your money, such as making an investment, borrowing money, or making a big purchase, do usually feel a) anxious, b) satisfied, c) hopeful, or d) invigorated? Or, how would you describe your pursuit of life’s dreams: a) cautious, b) measured, c) strategic, or d) fearless? Generally, your answers will correlate with your tolerance for risk, from risk adverse to highly risk tolerant.
Finally, your response to risk may be the most telling indicator of your tolerance for risk. Using the stock market crash of 2008 as recent point of reference, your response, either hypothetically or in reality based on your actual response, may say the most about your risk tolerance going forward. During the stock market crash of 2008 did you (or would you have) a) cash out all of your equities, b) reduce your equity exposure substantially, c) hold firm to most of your equity positions, or d) start adding to your equity positions.
It is very important to be mindful of the fact that your risk tolerance will evolve over time. This personal assessment should be conducted periodically to ensure that your current asset allocation reflects both your emotional and financial ability to tolerate risk. To figure out your emotional ability to handle risk, take our risk quiz here.