Understanding Risk Tolerance
“My 401(k) provider wants to know if I’m aggressive, moderate, or conservative? How do I know, and what are they getting at?”
While every financial institution has a desire to “get to know you better” so they can market products more effectively to you, this particular question about risk tolerance is one I want you to pay close attention to.
When I’m deciding how to invest my client’s money (i.e. stocks, bonds, mutual funds, ETFs, etc.), one of the most fundamental factors is understanding their risk tolerance. What is my client – let’s call him Andy (age 34) – what is Andy’s willingness and ability to take risk? How does he handle the large swings in his investment returns when the market is in a recession? Does Andy lose sleep over it? Or does he take a more balanced approach, note that he doesn’t plan to touch that money for many years, and remind himself that the market will make its way back up?
It’s my job to understand Andy’s risk tolerance so I can determine an appropriate asset allocation (percentage of investments in equities vs. fixed income) for him. Equities carry more risk than fixed income but historically they carry significantly higher returns as well. So, if Andy is a bit conservative when it comes to his financial life, then I wouldn’t place him in a high equity position. Why? Because he’d be more likely to panic when his eye catches the 6 o’clock news market segment “Dow Headed for a Crash” and he’d sell at the wrong time. In an attempt to protect himself from a potential down turn in the market, Andy has now jumped out of the allocation I created for him. The allocation that was focused on long-term growth and didn’t include these last-minute moves like shifting his portfolio toward more fixed income. And want to know the chances that Andy timed the market right and managed to avoid a big drop in his portfolio? Slim to none. The chances that Andy is going to miss out on the growth opportunity that occurs after a market correction? Considerably higher.
Andy’s propensity to panic and sell during market volatility would have a dramatic effect on his portfolio over the long-term. Speaking of long-term, another factor I need you to consider is your time horizon for using the bucket of money you’re saving. If you know that you plan to add to an account for many years, then your ability to take risk is higher. You can handle a few cycles of a down market because you are focused on long-term growth. Ideally, I’d be able to position you in a moderate/aggressive allocation to make your money work harder for you.
So now that you recognize this simple prompt for what it is – an attempt to understand your individual risk tolerance – how would you answer? Aggressive? Conservative? Be sure to take a few minutes to evaluate your own willingness to take on portfolio risk and get yourself into an appropriate allocation. Don’t be like Andy.