When it comes to investing, there is a lot you can’t control.
You can’t decide (or predict) market movements or how your investments will grow or decline.
While it’s challenging to predict the market or its outcomes, you can control how you participate in it. One way to do that is to understand your risk tolerance.
Your risk tolerance denotes your propensity for market risk, or how much uncertainty you’re willing and able to take on in your investments.
Breaking Down Your Risk Tolerance
Your risk tolerance looks at your comfort level with variability with the investment returns in your portfolio.
How can you gauge where you fall on the spectrum? A good place to start is by asking yourself the following questions:
- Would you be able to handle a 15% drop in your portfolio tomorrow?
- What level of a market drop would make you lose sleep at night?
- Does anything change if you think in terms of dollars vs. percentages? (i.e. losing $250,000 vs. 20% of your portfolio)
- What level of volatility and fluctuations are you comfortable with?
There are several in-depth risk assessment quizzes you can take to measure your specific risk tolerance. Your risk tolerance will help inform your asset allocation and security-level decisions. For example, an 80% equities / 20% fixed income allocation would align with aggressive risk tolerance.
But investment “risk” is about much more than your willingness to take on market volatility. It also assesses the following:
- Risk capacity (ability to take risk): A distinct metric centering on the amount of risk one can take to reach their goal.
- Need to take risk: A more subtle yet significant value that determines how much risk is required to meet particular financial goals.
As you can start to see, risk in investing is rather nuanced. It’s critical to understand each concept and how it relates to your portfolio and unique goals.
Risk Tolerance Is Only One Piece Of The Puzzle; You Also Need To Know Your Risk Capacity
You may know how much risk you’re willing to take, but do you know how much risk you can (or should) actually take?
The latter introduces the idea of risk capacity (noted earlier). Risk capacity is the amount of risk you should take to reach your financial goals. Calculating this figure means you need to have a deep understanding of your goals and what they cost.
You don’t want to take on too much or too little risk. What would this look like?
- Someone with a high-risk capacity could be a person who didn’t start saving for retirement until later. They will need a higher rate of return to meet their retirement goals, indicating a high-risk capacity.
- Someone with low-risk capacity may already be in retirement and doesn’t yet have substantial income sources like Social Security and a Pension. Assuming their nest egg is modest, they would have a low-risk capacity since they cannot risk losing much (or all) of what they have.
Using financial planning software, we can perform computer simulations to determine the percentage likelihood of reaching your goals based on thousands of trials. This exercise helps us determine the appropriate portfolio asset allocation and risk level for your situation. Doing so ultimately optimizes your financial planning results concerning your personal risk capacity.
Put It In Context With Other Investment Factors
To get a true understanding of your risk tolerance, you’ll need to be familiar with several other investment elements such as goals, time horizon, portfolio size, etc. All of these factors work together to help you build an investment plan that’s truly representative of your goals.
We are all human, and a drop in our portfolio balance can trigger an uncomfortable internal response that even the strongest-willed may find painful. Investing is emotional, and it is hard to always act rationally when it comes to money.
While risk can be uncomfortable, a portfolio without it will be subject to inflation, which will eat away at purchasing power and future financial security. Investing your money makes sense, but it isn’t always easy.
You must be able to weather financial storms as they occur. The longer the time horizon for each goal, the more time for the market to recover and, typically, the more aggressively you can invest. Together, we’ll assess your entire financial situation to ensure your investment plan is fine-tuned for success and something you will feel comfortable sticking with for the long term.
One specific way we help clients manage risk is to ensure their expenses are covered. Even more, we recommend our retirement clients keep at least 5-years of living expenses outside of the stock market in safer investments to protect against any unpredictable market movements. With this approach, you can find strength and certainty in hard times since you have the resources to “wait it out” and let the market recover.
The goal is to avoid panic selling when the market wobbles and stick with your comprehensive long-term plan.
Why Risk Tolerance Is So Important For Long-Term Investing
Your risk tolerance is a critical variable within your investment plan.
By taking on more risk than you can handle, you open yourself up to market anxiety and potentially pulling money out of the market when you shouldn’t. There is also a real danger in playing your investments too safe and not reaching your financial goals.
It is essential to discuss what might happen to a portfolio ahead of time; that way, it will never be a surprise. If history is any indication, we can set our expectations and mindset to plan for the following:
- A 5% pullback in your portfolio every year
- A 10% pullback in your portfolio every couple of years
- A 20% pullback in your portfolio at least every five years
Putting these in dollar terms early on helps you envision what you might be able to stomach in real life.
Risk tolerance is just one part of an ongoing conversation about your comprehensive investment plan. Understanding and actively discussing all the facets of risk upfront is critical to investing and retirement planning success.
Understanding your risk tolerance is a critical step to building an investment strategy that will work for you long-term. Are you ready to more deeply understand your relationship with risk? Take our quick, 5-minute risk assessment. Your results will help inform our conversations about risk and illuminate a strong path forward for your investment practices.
If you have not thought about risk in this way or would like to learn more about how we can help with your portfolio and your financial goals, please contact us.
Craig Toberman is a Partner at Toberman Becker Wealth – a fee-only, fiduciary financial advisor based in St. Louis. He assists families and businesses with strategic financial planning and long-term wealth management. He has over a decade of experience in financial services and has crafted custom financial plans for hundreds of families and businesses.