Understanding your true investing risk tolerance goes much further than checking a few boxes on a risk tolerance quiz.
Investment risk encompasses several broad concepts, with multiple iterations of each. Longevity risk encapsulates the possibility that you’ll outlive your money. Risk tolerance taps how much of an investment loss you can psychologically withstand.
Jason Escamilla, CEO at Impact Labs in San Francisco, describes a two-step plan for tackling client risk: First, protect the client’s wealth and second, ensure they can meet their goals. When approaching risk, Escamilla incorporates both emotion and analytical risk analysis.
Here are a few steps for protecting your mental health and financial wealth by understanding your risk tolerance:
- Define what you consider to be riskier assets.
- Access your risk tolerance.
- Categorize your risk level.
- Manage your risk.
When discussing risk, it’s common for the investment community to focus on standard deviation or volatility of investment returns. The standard deviation of investment returns measures how far from the average annual investment returns plot on a graph. When applied to annual investment returns, past returns are used to calculate the current standard deviation.
A standard deviation close to zero means that the returns are consistent and approximate the average. A certificate of deposit has a standard deviation close to zero. Invest $1,000 in a certificate of deposit, and as long as the investment is owned until maturity, the consumer receives the stated interest rate.
For a riskier asset, the 10-year average standard deviation of the SPDR S&P 500 ETF (SPY) is 12.69. A higher standard deviation means that there’s a likelihood that returns will deviate from the mean, both up and down.
Riskier assets, like stocks, have more dispersed returns and typically a higher standard deviation. For example, since 2008, the S&P 500’s (.SPX) greatest loss was in 2008, with a decline of 36.55%. While in 2013, the S&P 500 gained a 10-year record of 32.15%.
An investor seeking higher returns must also accept the possibility of greater losses.
Longevity risk is akin to risk capacity and relates to the possibility of an investor outliving her wealth. Wealthier individuals have a high-risk capacity or low-longevity risk. Those with more limited means have a greater chance of outliving their assets.
A wealthy investor might have a low-longevity risk and still be uncomfortable with investment losses. This investor would be conservative, despite the portfolio’s ability to withstand losses.
“Risk tolerance is a concept that can be difficult to gauge with clients. A client's risk tolerance can change with the direction of the market. When the market is doing well, clients want to be very aggressive and when the market is experiencing some downward volatility, clients can be fearful and want to go to cash,” says Mario Hernandez, a certified financial planner at Gemmer Asset Management in the San Francisco area.
Gemmer has a unique strategy to assess client risk. He educates clients with data, describing past stock market declines and then asks them how they'll sleep under those circumstances. That informs the level of risky equities to include within a client portfolio.
Brandon Renfro, an assistant professor of finance at East Texas Baptist University, uses a similar approach. For older investors, he asks clients what they did during the onset of the Great Recession and then queries them about how they would react to a future stock market drop.
Typical risk tolerance questionnaires ask investors about how they would respond to distinct levels of investment declines. Typical response choices include sell, hold, or buy more of the risky asset after a decline. Investors' responses attempt to describe individuals' risk aversions.
But these risk quizzes are historically inaccurate and the more “in vivo” discussions of Renfro and Gemmer are likely to yield more accurate risk-tolerance levels.
Categorizing risk levels
The simplest way to categorize risk levels is by time. Short-term investors who will need their funds within one to four years should invest conservatively, with minimal exposure to equities and the greatest allocations to cash and short-term bonds. That’s due to the unpredictability of the stock market in the short term. Investors don’t want the $50,000 downpayment for their new home to be worth $40,000 in two years when they are ready to buy.
In contrast, one might assume that long-term investors are aggressive, but that assumption is too simplistic.
In the long term, over decades, stock prices trended upwards. But the positive stock market average returns over the long term mask short-term volatility. Realistically, the future is uncertain and there are no guarantees that the upward trend of stock prices will continue. That’s why assessing risk tolerance is tricky.
For the mid- to the long-term investor, risk levels will vary from conservative to aggressive. The risk level is represented by the amount of loss an investor is willing to withstand. Even an investor with great wealth may not be willing to tolerate the loss potential of a stock-heavy investment portfolio.
A conservative investment portfolio typically holds between 70% and 90% cash and fixed assets, with the remainder in stocks. While an aggressive investment portfolio ranges between 80% and 90% stock investments, with the remainder in bonds.
The most common risk tolerance levels vary between conservative and aggressive, with conservative portfolios owning fewer stock assets and more aggressive ones owning greater amounts of riskier holdings.
“To manage risk, we believe that it is essential to diversify your assets – whether your risk tolerance is conservative, moderate or aggressive. We recommend reviewing your investment goals, risk tolerance and time horizon with your financial professional on a regular basis to make sure they are aligned with your asset allocation,” says Chris Haverland, an asset allocation strategist at Wells Fargo in Greensboro/Winston-Salem, North Carolina.
Diversification reduces portfolio volatility so that if one asset class loses value, others will offset the loss with investment gains. That’s why it’s important to own stocks, bonds and possibly other financial assets like real estate.
Some investors prefer to manage risk with a passive portfolio. In this scenario, the investor maintains a constant mix of assets such as 60% stocks and 40% bonds. While others prefer to manage risk actively by adjusting investments according to market and economic conditions.
Rick Lear, chief investment officer at Lear Investment Management in Dallas takes an active approach to risk management. Lear conducts in-depth research to determine which asset classes might go up. Then the firm heavily weights the asset classes projected to rise in the future, considering both the research and the economic cycle.
Victor Haghani, chief investment officer at Elm Partners in Philadelphia, uses an active value and momentum-based asset allocation strategy. The unique Elm Partners algorithms manage risk by integrating value measures into their asset selection and overlaying those asset class picks with a momentum screen. All clients of Elm’s managed portfolio sign up for an asset allocation that adjusts according to an active assessment of fundamental and momentum factors.
Understanding risk tolerance is an active process that incorporates personal, economic and market factors. It’s important to understand one’s time horizon, risk tolerance and risk capacity before constructing an investment portfolio. A comprehensive understanding of investment risk will minimize the likelihood of buying high and selling low.
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