Every investor is unique so there can be no precise algorithm or formula for determining risk tolerance. Here are some principles to keep in mind as you choose your own level of risk tolerance:
- Volatility is typically a two-way street, so the higher the profit for which one aims, the greater the losses one must be willing and able to tolerate should things not pan out as one hopes.
- Stability is also typically a two-way street, so the more steps one takes to limit the frequency and/or size of potential losses, the more one will also wind up having done to limit potential gains.
The two-way risk-return tradeoff is real and inevitable, not simply a saying or a statistically observed phenomenon. Click here to find out why.
Focus on two major themes when assessing risk tolerance:
- Affordability (i.e. ability to withstand losses)
Affordability considerations: Consider the ability of an investor to withstand losses without damaging an investor’s ability to satisfy his or her needs and achieve his or her goals
Generally, the older the client, the more conservative. But that’s not always so. The stereotype comes from the idea that older people are more likely to have immediate need for funds and be unable to tolerate even temporary losses (i.e., it would be no comfort to know the market will recover in five years if one may need to draw funds later this year). So regardless of age, hone in on potential near-term need for funds:
- Are Income/Withdrawals needed to fund basic living expenses for the investor and dependents?
- Are there any especially large expenditures on the horizon?
College? House? New car? Major vacation? Major health-related item?
- Are Income/Withdrawals needed to fund basic living expenses and/or large expenditures for others?
Young people supporting elderly family relative may have to be more conservative than young people who are not supporting others outside the household
- How secure is one’s regular income?
A young person with an insecure job should be conservative.
- Allocation of funds
It can never be assumed that a particular portfolio represents all or a portion of an investor’s total wealth. The smaller the portion and/or the more secure the remainder, the more risk that can be taken with the portfolio under question (which, if a small enough portion of the total, might even be described by the investor as “fun money”). On the other hand, the more substantial the portion, the more conservative one may need to be.
Temperament: Since investing addresses the unknowable future, consideration needs to stretch beyond mere numbers. Temperament matters too.
While an investor should never be encouraged to assume more risk than is affordable, (regardless of how adventurous one’s personality), it can be prudent to tolerate more conservatism than may be warranted based on numerical analysis alone. Investors have the right to try as best they can to maximize their personal levels of comfort.
Temperament can be assessed through questions such as these:
Are you a worrier?
- Do you look at the news every day and think to yourself “Oh my, this looks bad, what will we do? We’re doomed!” and find your pulse quickening?
Are you adventurous?
- Would you rather ski or surf than watch others doing it on TV?
- Do you look at news reports of disasters and think “That’s terrible, but we’re resilient and will overcome.”
What is your gut-level reaction to significant market declines (the sort to which the media give extra attention)?
- If the first impression is to think about selling, this suggests a conservative temperament.
- If the first impression is to wonder what buying opportunities may be out there, this suggests an aggressive temperament.
What is your gut-level reaction to significant market rally (again, the sort to which the media give extra attention)?
- If the first impression is to think about profit taking, this suggests a conservative temperament.
- If the first impression is to consider investing more, this suggests an aggressive temperament.
NOTE Re: Temperament assessments/interviews/questionnaires in general
It’s always challenging to answer questions like these in hypothetical settings. If one is to err, it’s better to err on the conservative side.
One can always change a risk tolerance choice later on if it turns out the initial choice was not the best one. The goal, at the outset, is to maximize flexibility in this regard.
- If one is too conservative on day one and later decides more risk can be assumed, the worst that will have happened is that the investor will have forfeited some opportunity for excess gains. But at least as much of the principle as possible (given the interplay of the market and the low-risk choices that were made) will still be available to the investor.
- If the initial choice was too aggressive, the investor runs the risk of having sustained possibly significant losses before being able to readjust.
If one is completely undecided, choose a Balanced risk, examine the allocations, and then experimenting by altering the risk-tolerance settings and noticing the changes in the allocations.
The ultimate fail-safe approach: CREATE AND MONITOR PAPER PORTFOLIOS and commit real funds only after truly understanding the impact of risk-tolerance choices through actual experience and observation.