Am I Risk Tolerant?
We see advisors and investment firms do it all the time. They ask you what your risk tolerance is, possibly on a scale of 1-5 or with words like conservative and aggressive. But can you capture the intricacies of risk and reward in a few words or multiple-choice questions? We don’t think so. Let’s take a deeper look.
There is a clear connection between risk and return. A riskier portfolio can deliver more return… and more volatility. So getting your risk level right is critical. If you can define what risk means to you, you can figure out how much you can accept, or not. First, here is a look at the ways the industry defines risks:
- What the regulator says about risk: “A scale of low-medium-high” – Whatever that means, it’s simply inadequate. One word is not enough.
- What the academic says about risk: “Volatility is risk” – Watch the bouncing ball? It’s not enough to measure life in standard deviations.
- What your income and expenses say about risk: “Net savers, people who spend less than they earn, can reduce their risk” – Now we’re getting somewhere… a practical connection between you and the contents of your portfolio.
- What your net worth says about risk: “Based on what you expect to spend, you may have more than you need.” Net worth and your spending habits focus attention not just on risk tolerance, but on risk need. There’s no reason to carry more risk than you need. Another step in the right direction.
- What your age says about risk: Joint life expectancies are approaching the 90’s and 100’s. We encourage playing the long game, especially when there are future generations in the picture. Fortunately, time is an asset.
- What your gut says about risk: You have to feel comfortable. We’ve met ultra wealthy people who feel they don’t have enough money and moderately wealthy people who feel they have more than they need. Regardless of the numbers, you don’t have to take more risk than you want. That might mean holding a high minimum in just-in-case cash.
Risk and fear are personal. You can attempt to pre-package an emotion into a formula. Many have tried. It ultimately doesn’t work.
Conversations not data entry
The financial industry frequently gets risk wrong by trying to take shortcuts. No questionnaire or algorithm can capture the nuances of your life and your financial priorities. The portfolio that’s right for you must take everything into account – financial liabilities, mortgages and loans, your current and future income, net worth, big expenditures, and your gut fears and concerns. Further, your risks are always changing. See 6 Reasons To Call Your Advisor. We can help you get it right. We typically start with three open-ended questions, “the three power questions”, that help us understand you, your goals, and your feelings towards risk. We welcome the conversation.
Lost in translation
“I didn’t know what I was answering.”
We’ll leave you with a story about a woman we know who filled out a survey when she opened her investment account at a big investment firm, we won’t say who specifically, but it rhymes with JP Schmorgan. Rather than having the discussion, she checked a multiple choice box that said she was ok with a -15% to -20% drawdown. When the market fell by that much, and so did her portfolio, she was shocked, unprepared for the swings and upset with her advisor and the firm she had trusted. Ultimately she had an unfortunate experience because her portfolio didn’t match her REAL goals. That could have been avoided. Where was the conversation?
Max Osbon – email@example.com