Anyone who’s invested in the market for even a short time likely has heard the term “risk tolerance.” When applied to a stock-and-bond portfolio, risk tolerance includes factors such as age, time until retirement, income needs and the “sleep at night” factor, which simply refers to an investor’s level of anxiety about the market.
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How should investors determine their risk tolerance? It can be a tricky question to answer, as a person who is particularly anxious may keep the bulk of his or her assets in cash, which won’t generate the return most retirees need. Bonds may feel safer to some, but fixed income also underperforms equity.
Taking too little risk can lead to portfolio underperformance relative to what a retiree needs. Too much risk can lead to sharp downturns at just the wrong time.
Here are some factors to consider when determining your risk tolerance and the mix of investments you want to include in your portfolio:
What is risk tolerance in investing?
How risk tolerance affects investing goals.
When to assess risk tolerance.
Advisor vs. self-evaluation of risk tolerance.
Conflicting risk tolerances in couples.
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What Is Risk Tolerance in Investing?
Amanda Kaphammer, an independent financial consultant and founder of Sol Spyre in Bend, Oregon, says risk tolerance can be considered a person’s willingness, ability and need to take risks.
“Willingness to take risks is a person’s attitude about risk; one person may be an adrenaline junkie willing to embrace risk with a devil-may-care attitude; another finds the idea of bungee jumping off a bridge absurd and prefers to keep their feet planted on solid ground,” she says.
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She adds that ability to take risks accounts for an investor’s preparedness to weather the unexpected. For example, does he or she have a sufficient emergency fund and proper insurance coverage?
The need to take risks is tied to the sort of projected return on investment that is required to achieve that person’s financial goals.
“What are we aiming for, how much will it cost, and when would we like it to happen, also known as the goal, the funding and the time horizon,” Kaphammer says. When those questions can be answered, she adds, an investor or financial advisor can map out a plan to best achieve the necessary return.
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How Risk Tolerance Affects Investing Goals
Scott Butler, financial planner at Klauenberg Retirement Solutions in Laurel, Maryland, underscores the need for investors to understand how much it will take to fully fund retirement.
“Each dollar should be linked to a purpose so that it can be invested appropriately accordingly to the time frame,” he says. “This usually means that not every dollar should be invested at the same level of risk. Even the most aggressive investors should be conservative with money they need to pay the mortgage next week.”
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He adds that there’s an essential difference between the amount of risk investors need to take to achieve a goal, and how much risk they want to take.
“Being too conservative may be the surest way not to achieve your goals,” he cautions. “Conversely, if you can achieve all your goals with a lower rate of return, you need to consider if it is worth taking on additional risk for the chance of a higher return.”
When to Assess Risk Tolerance
Investors must also recognize that risk tolerance can change depending on market and economic conditions or circumstances specific to a person’s life, among other factors.
Joel Larsen, principal at Navion Financial Advisors in Sacramento, California, says the way to get a true tolerance for risk is to assess it in or shortly after a difficult down market.
“Assessments made when everything is coming up roses will default to be optimistic,” he says.
His firm, like many others, uses a risk assessment tool called Riskalyze to quantify risk and establish an investor’s expected return.
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“Risk tolerance in and of itself does not move even as we age, as it is part of the client’s psychological makeup,” Larsen says. “What can change is the amount of risk you build into the portfolio at any given point in time, depending on current risks in the markets. We do not set it and forget it.”
Risk tolerance must be a moving target, says Scott Sturgeon, founder and senior wealth advisor at Oread Wealth Partners in Leawood, Kansas. “Humans don’t live our lives on linear paths or even like the financial projections we show to clients in meetings,” he says. “Life is messy, and that’s a good thing. People lose their jobs, quit their jobs to start businesses, children are born, parents pass away, people get older, and all kinds of other life events (happen) in between.”
He adds that major life events will have an impact on an investor’s financial situation and financial goals, as well as attitudes toward risk.
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Advisor vs. Self-Evaluation of Risk Tolerance
Investors working with a financial advisor can get help formulating a risk-appropriate plan designed to generate the return they need. But the process can be more difficult for those flying solo.
“Investors without an advisor can approach risk tolerance by evaluating their own financial goals, time horizon and personal risk tolerance,” says Michael Ashley Schulman, partner and chief investment officer at Running Point Capital Advisors in El Segundo, California.
He acknowledges, though, that unbiased self-evaluation is difficult.
“I’ve met many people who consider themselves conservative but are actually aggressive, and vice-versa,” Schulman says. “Much depends on their frame of reference.”
He notes that people are often aggressive in some aspects of their life and conservative in others.
“We’ve all seen the person that rushes down the highway like a maniac, but then takes five minutes at the grocery store to select a loaf of bread,” he says. “Self-analysis without guidance is challenging; you can consider using online risk tolerance assessments or working with a financial professional on a limited basis.”
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Schulman says it’s important for go-it-alone investors not only to understand the relationship between risk and reward, but also the value of income streams and what they can stomach when portfolio values decline.
Conflicting Risk Tolerances in Couples
It’s not uncommon for spouses to have different levels of risk tolerance.
“When two people in a relationship have different risk tolerance levels, it can create tension and disagreements that can be difficult to manage,” says Andy Laino, certified financial planner for Prudential Financial in Sarasota, Florida.
“The best way to handle this situation is to first understand and accept each other’s risk tolerance levels,” he says. “It’s important to remember that risk tolerance is a personal preference and that neither person is wrong for having a different opinion.”
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With these couples, Laino will first do a risk assessment for each individual, then discuss how to implement the appropriate asset allocations.
“Once we have this base level of communication, we can negotiate a level of risk that each party is comfortable with,” he says. “Coming to a mutual agreement or compromise on the money is a great learning experience that might be needed for other financial or family issues. Negotiation is key to finding a balance that works for both parties.”
