The Importance of Your Risk Tolerance
Our relationships with clients always begin with understanding your current financial situation and your financial goals. The information that we gather in our initial meetings form the financial plan that we develop with you. That information and that plan include your risk tolerance, or how conservatively or aggressively you can and want to invest. Here are 4 questions that explain how and why we make risk assessment part of our financial planning process, and how risk tolerance can change over time.
What is your goal?
We start our financial planning process by understanding who you are, your needs, and the goals that are most important to you. One of the most basic questions we can ask is, “What are you investing for?” For one person, it might be a house they want to purchase in the next five years and for another, it might be for retirement that is still thirty years away. The short-term vs. long-term goal-setting helps determine the amount of risk you are willing to take. If you are saving for retirement well in the future, you could consider investing more aggressively than for a shorter-term goal.
How can we balance risk and gains?
Everyone wants enhanced returns with lower risk, but in nearly all cases you have to accept more risk to achieve greater returns. Part of determining if you are a conservative, moderately-conservative, moderate, moderately-aggressive, or aggressive investor depends on your goals, risk tolerance, age, and any special circumstances. Younger people typically can accept more risk given they generally have a longer time horizon, however a young person saving to purchase a home in a year should not accept the same risk as someone of the same age saving for retirement given the different time horizons and goals. Similarly, someone with a short-term time horizon should avoid illiquid assets as those assets are set to be used at a specific time for a specific purpose in the future. It is not uncommon for investors to naturally become more conservative over time as their portfolio grows and they are nearing retirement when market volatility can be more impactful. As time horizons decrease, market volatility can be more costly leading to a potential decline in risk tolerance.
In my last blog post, I explained the basics of the Dollar Cost Averaging (DCA) strategy of investing. Adding to your portfolio even as markets dip or rise can eliminate trying to time the market and instead focus on time in the market. Appropriately aligning your portfolio with your risk tolerance can help reduce stress during down markets knowing you have a strategy in place.
Where is your risk level?
Part of investing is understanding the type of investor you are, which includes the amount of risk you are willing to accept. Sometimes I compare it to the risks you would be willing to take when going on vacation – would you go cave diving or swimming with sharks, or just want to relax on the beach? In addition to a conversation, we use a risk analysis software. Our software includes a questionnaire that puts a number on your investing risk tolerance from one to 99. One is the most conservative, where you’d have all your money in cash, while 99 is ultra-aggressive. This report also shows the potential upside and downside of the risk level.
We design a portfolio based upon your determined comfort level with risk and review this proposal to see how you feel about it. Then, we have a conversation and educate you about the decisions you are making when it comes to your risk. Finally, we make any necessary changes – increasing or decreasing risk tolerance.
When does your risk tolerance shift?
Your current risk tolerance isn’t your risk tolerance forever. While the DCA is set-and-forget (which should still be reviewed and analyzed regularly), risk tolerance is not. We evaluate risk on a client-by-client basis. And when clients get closer to the goal, especially if that goal is retirement, they get less and less aggressive. During our client reviews, we continue to talk about goals and risk tolerance and have a conversation regarding progress toward your goals and any changes that might be appropriate.
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