What is my risk tolerance?
Written by Rick Welch
To understand the concept of risk tolerance, ask yourself this question. “When will stock market losses in my portfolio keep me up at night, or said another way what is my threshold for pain?” Take a few moments and consider how your peace of mind would be affected by a long and deep stock market correction. Risk tolerance, a subjective concept, then refers to our investing psyche and ability to remain unaffected by market volatility. Since your risk tolerance is determined by your comfort level with uncertainty, you may not be aware of your true capacity to accept risk until faced with a potential loss. As investors, it is important to develop a psychological detachment that is present during both bull and bear markets. If you are like me, you probably enjoy checking your stocks during good times and avoid the business section of the newspaper during bad ones. That is ok, but, remember that good investing opportunities often present themselves in the meanest of bear markets.
Risk tolerance must also be viewed from an objective perspective. It is more than a reflection of investor emotions, in fact, it is an assessment of how much investment risk you are willing to accept. This capacity to accept risk is based on your financial needs, objectives and investing time horizon. Risk capacity is dynamic and may change often depending on your personal and financial goals and your timeline for achieving them. The shorter our investing time horizon (or when we need our money), the less risk we should be willing to accept in our portfolios. What is my risk limit? How much risk do I need to take in constructing my portfolio to give me the best shot at accomplishing my investing goals? How much of my stock investments can I afford to lose during a stock market correction before my investing plans are derailed? Do not limit yourself by allowing your own sense of loss aversion (the fear of loss) to play a bigger role in your investment decision making than the anticipation of future stock market gains. Proceed with the understanding that your risk tolerance sets the foundation for your portfolio in that it suggests your ideal asset allocation – the best mix of stocks, bonds and cash.
Your investment portfolio is based on a strategic asset allocation plan that delineates the percentage of assets earmarked for stocks (capital appreciation), bonds (income generation) and cash (safety and liquidity). What asset allocation is right for you? Do you consider yourself to be a conservative (less than 20% stocks), balanced (50% stocks and 50% bonds) or aggressive (over 80% stocks) investor? A simple rule might be that if you were to subtract your age from 100, your answer could be an estimate of the percent of stock holdings in your portfolio. Thus, at age 57, a starting point for my allocation to stocks might be 43%. (My current risk profile is 55% stocks, 40% bonds and 5% cash.) This is overly simplistic, but, it demonstrates the point that for most investors, age and portfolio stock holdings (%) are inversely related. Using this example, at age 67 a starting point for my allocation to stocks would have decreased to 33%. So, what does this mean to you? You need some risk in order to increase the probability of higher investment returns. In order to keep your retirement plans on track you must choose an asset allocation that considers appropriately your risk tolerance and fits your investing goals and objectives. There is no right or wrong answer – choose the allocation that you feel best balances expected risk and return in a way that aligns strategically with your financial needs, objectives and investing time horizon and gives you peace of mind.
