The biggest problem with the investment industry is sometimes we need a special dictionary to understand what’s really being discussed. Take the word “risk”, for example. Do we really understand what it means – in relation to ourselves, our investments, our life goals?
Risk can mean something different in each of these contexts. A passion for zip-lining or blackjack does not necessarily translate into an ability to take more risk with our investments, nor does being a successful entrepreneur; in fact, it may mean taking less risk with our investments.
What is Investment Risk?
If you’ve ever invested your money in anything other than a savings account, you been asked about your “risk tolerance” and amount of investing experience. This is because every other asset in the world fluctuates in value. This is a concept that first-time investors truly struggle to understand. Investments with potentially higher returns are going to fluctuate more in value. This is what’s called “volatility” and it’s the price one pays for the possibility of achieving higher returns over the longer term. To estimate returns, experts look at the historical returns of different types of investments and measure both the very long-term average returns and the amount of volatility the asset exhibited. What is long-term? A least a decade, ideally several decades, to reflect the ups and downs of several economic cycles and market environments.
What is Risk Tolerance?
So, investment risk tolerance is a gauge of how much fluctuation in value you could experience and still sleep at night. There are a number of factors that contribute to one’s theoretical ability to take more risk: age, net worth, earning power, steady sources of income, to name a few. However, much more important is the “willingness to take risk”, or our investment “comfort zone”. This is the amount of emotional distress we would experience when our investments fluctuate in value and the point at which we would abandon our investment program and start running for the exits.
How Do I Gauge my Risk Tolerance?
Experience is the best teacher. That’s why investment advisors ask about your investing experience. Since we’ve been in a bull market for a decade now, many people have not experienced a major stock market or real estate market correction. Starting out more conservatively, or with a smaller portion of your funds until you’ve experienced a market swing or two is a smart thing to do. For more experienced investors, a key question might be: How did you react in 2008-2009 when the market fell 50%? If you stayed with your investment program or added to it, then your risk tolerance was higher than most. But it might have changed since then. Ask yourself, “where is it today?’
Determining risk Tolerance
Ongoing conversations with your wealth management professional are the best way to determine the amount of portfolio risk appropriate for you. Questionnaires are often used but these are just a start and many are overly simplistic. A better risk tolerance analysis delves into what’s called behavioral biases – emotional and thinking responses that are unique to each person. An advisor or portfolio manager with some professional training in behavioural finance will align your portfolio to your personal investor type.
Will My Risk Tolerance Change Over Time?
Yes! It will change but perhaps not as you expect. When people retire, for example, they may want to take less portfolio risk because they’ve stopped contributing to, or may be drawing from, their portfolio. But this isn’t always the case. With increased life expectancy, investing part of your portfolio for long-term growth may be just as important as it was in the past. If you expect your portfolio to support you for twenty to thirty years and keep pace with inflation, too little portfolio risk introduces another type of risk: the possibility that you might outlive your portfolio. Most people say that this risk, called longevity risk, is their greatest fear.
We fear what we don’t understand. A little reading, (like this post, for example!), can help you get more comfortable with the concept of investment risk. And, growing experience with investing will enable you to take more portfolio risk in time – or not, as the case may be. Once you know your real comfort zone, you can focus on other factors affecting your ability to take risk and structure your portfolio accordingly.