Risky Business: Understanding Your Risk Tolerance Is Key to Financial Success
April 28, 2022*
Webster’s defines risk as “the possibility of loss or injury” and while this is true, risk—in the investment world at least— also means opportunity. In the simplest of terms, without risk, there is no reward. The key is determining the appropriate amount of risk for the reward you are seeking. This balancing of risk and reward is the foundation of all the work we do for clients and is critically important to long-term financial success.
Without a thorough understanding of a client’s risk profile, it would be impossible (and unethical given our commitment to fiduciary standards) for us to recommend an appropriate investment strategy. A strategy that is too aggressive could send you running for the exit at the first sign of a market correction or keep you up at night even if you are able to stick with it. A strategy that is too conservative may not keep pace with your desired withdrawal rate over time, requiring a possibly painful cut in retirement spending or risk running out of money before the end of your life. None of these scenarios are desirable. An investment strategy is intended to be long-term and enduring but subject to gradual adjustments as circumstances change over time, when you prepare to retire, for example. These changes should be driven by your evolving needs, not by market performance. It is for these reasons that we spend a considerable amount of time with clients to understand the following three aspects of risk that are unique to each individual:
Risk required: What does your portfolio need to return in order for you to meet your goals? First and foremost, we want to be sure you aren’t taking on more market risk than necessary in order to meet your goals. Finding the right asset mix— not too conservative and not too aggressive—and the possible return scenarios for your ideal portfolio is extremely important.
Risk capacity: How much loss can your portfolio suffer before you threaten your long-term security? What is your investment time horizon? Generally speaking, those investors who have less immediate need for the funds in their portfolio possess a greater capacity for risk taking. Simply put, portfolios that have more time to recover from losses sustained in a market correction can undertake a more growth orientated investment approach.
Risk tolerance: This is the “gut check”. How much risk can you stomach without hitting the panic button? While current market volatility may be testing you, you may be surprised to learn that risk tolerance remains very consistent once you’ve reached early adulthood. According to data from FinaMetrica, a leader in gathering risk tolerance scores, market fluctuations have almost no effect on risk tolerance. What can change as markets rise and fall is simply the perception of risk.
The turbulent market we’ve experienced so far in 2022 may have you thinking more about risk and your portfolio than you typically would. If your needs haven’t changed, the best course of action is to be mindful of your spending and simply hang on tight.
*Originally published on January 27, 2016 and updated on April 28, 2022
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