Determining Your Risk Tolerance
Long-term investing transpires like a cross-country journey over an unpredictable terrain with several highs and lows. Since the market is always moving and you can’t control its direction, your investment plan should focus on one known feature: your desired destination, or the current financial goal your portfolio is designed to achieve. That kind of road map provides a clearer view of the investment risks you need to take to get the returns that’ll get you there.
Determining your risk tolerance is an important part of mapping out an investment plan; it helps keep you invested and moving toward your goal, even as markets invariably test your financial and psychological fortitude. Risk tolerance is a guide for choosing an asset allocation – the proportions of money invested in different assets – that gives your portfolio a risk level you’re comfortable with and expected returns to reach your target.
Two studies, one in 1986 and one in 1991, by researchers Gary Brinson, L. Randolph Hood and Gilbert Beebower concluded that your asset allocation accounts for over 90% of its long-term return and risk characteristics. So, it is essential to determine and stay within your risk tolerance to avoid making asset allocation decisions that may adversely affect growth in your portfolio.
Sometimes, investors determine risk tolerance from a self-analysis of their behavior, as in the losses they think they could withstand in a down market before abandoning their asset allocation and moving their money. Likely, at the wrong time. Investors also ditch their investment plans during good times by buying the day’s hot stocks, even if they increase risk. Whether hitting the brakes on investments or stepping on the gas to catch the market, both actions can change the probability of reaching your goal.
Thus, one rule of the road is to keep emotions in check when investing for the long haul.
The Risk Tolerance You Need
For the surest route to funding a particular goal over time, such as retirement income or a legacy for your children, your risk tolerance should be the lowest risk necessary to generate enough growth, because lower volatility gives you a higher probability to succeed by helping you stay invested. Therefore, think of risk tolerance in relation to your goal – what risk level will best limit the direct effect of market swings on reaching your goal instead of the amount of risk you think you can afford to take.
Potential growth in your portfolio is related to its level of risk. In other words, risk is necessary when investing. However, you can partially control risk in your asset allocation. Assets with expected returns to meet your goal at the lowest risk offer a better chance at a smoother ride. Selecting an asset allocation based on the long-term risk to generate the returns you need rather than the risk that matches your long-term behavior can make daily market changes during your investment journey less emotionally consequential.
The Benefits to Maintaining Risk
There’s a good reason roads wind up and down mountains rather than straight along their slopes, and there’s a good reason to seek steady but not steep returns. Steep gains and losses, or high volatility, make for a bumpy investment ride and increase the urge to make decisions that can affect your long-term financial goal.
Maintaining your allocation – and therefore, your risk tolerance – helps prevent you from reacting to market swings. Rebalancing – selling gaining assets and buying declining assets – your assets to their original levels reduces accumulated risk, which helps keep your allocation within your risk tolerance and desired volatility.
With less volatile returns over the long term, there’s a lower chance of having to recover from a steep loss. This is especially difficult when a steep loss occurs at the end of your journey – possibly putting your destination out of reach. Markets drops are relatively common. According to research firm the Leuthold Group, bear markets happen nearly every 4 ½ to 5 years. Therefore, on a long investment journey there’s no good reason to race to generate more money than what your goal requires – you’ll put yourself at risk of running out of gas.
When to Reassess Your Risk Tolerance
While it is important to stay on the road to your financial destination, there are circumstances when it becomes reasonable to adjust your investments and, subsequently, your risk level.
For one, if a fortunate string of market gains brings you very close or right to your financial goal, a more conservative investment approach, such as increasing allocation in bonds, may be appropriate. But remember, some risk exposure is necessary for continued growth to offset the rising cost of living caused by inflation. Conversely, a long market downturn may move your goal further away and warrant consideration of a more aggressive approach.
Also, reassess investments upon life changes in estate planning or personal finances.
Hiring an Advisor for the Ride
The steps needed to build and follow an investment plan compel some investors to not take their investment journeys alone. Financial advisors can act as a navigator or, better yet, a voice of reason by providing perspective for you to stay on the road toward your destination. They can help determine which assets offer the highest probability and lowest risk. Advisors also provide the discipline to rebalance your portfolio and maintain its original risk levels, like a hired hedge against emotional reactions to short-term market events.
Keep in mind some advisors have a financial incentive to push you toward a higher risk tolerance in order to sell certain products. Therefore, always thoroughly research an advisor’s history, fees and any third-party affiliations.
The more you monitor your financial journey – that is, track the day-to-day markets – the more likely you are to lose sight of your financial destination. Determining risk tolerance in relation to your goal and working with an adviser can reduce the potential for risky investment behaviors. You’ll be better off mentally and financially by saving your emotions for the fulfillment of your goal after a long journey down Wall Street.