Of the many topics that need to be covered in order to understand financial planning and investing, risk tolerance is likely the most important. The problem with risk tolerance is that there is no right answer, and for each and every person has a different level of risk tolerance.
In my previous job as a banker, when I’d ask questions to a client, much like the questionnaire I’m going to be directing you to in a bit, our system would determine the level of risk the client would be willing to take and determine the investor type of that client. In my previous job there were 6 levels from extremely secure clients that could only purchase term deposits to extremely aggressive clients that could buy pretty much anything of course with some limits. And there were 4 levels in-between, which would have asset allocations that would be determined accordingly.
Let’s go through how you can determine your risk tolerance and what other things you will need to consider as you look to construct your investment portfolio.
Why this needs to be done
First let’s talk about why this needs to be done in the first place. If you walk into a bank or talk to a broker they’re going to need information from you before you can even talk about investments. This is required by securities regulations as the advice that is provided needs to be tailored to your needs, which is tailored around your risk tolerance.
Regulations aside, knowing how much risk you can handle gives you an idea as to what sort of return you can expect. We always hear that you need to take more risk for a higher return. While this doesn’t always ring true, for the most part you aren’t going to get a 10% annual return when you’re invested in term deposits, well at least not in most countries.
As a result, once you know what your risk tolerance is, you can build a portfolio around that asset allocation.
Determine your Risk Tolerance Level
If you do a Google search for risk tolerance questionnaire you’ll see many especially from discount brokerage sites. Without any bias, I’ll provide one example this is only for illustrative purposes so I do suggest you try to find others as well.
A questionnaire that I found on the Rutgers University website. Please note that I have no association with this University or this questionnaire.
As you can see these questionnaires can be cumbersome. And most of them have 10-20 questions that give you different situations to see how you would react. Make sure you take these questionnaires seriously. You want your answers to truly reflect how you think subconsciously. Some people passively answer these questions and end up with a risk tolerance level that doesn’t suit them and this can lead to all kinds of problems.
Now that you’ve done the questionnaire, let’s look at some of the components that determine your risk tolerance level.
Components of risk tolerance
Age and Timeframe
First, your age is a big factor as this can be linked directly to the retirement portion of your portfolio. You can’t take the same amount of risk with a portfolio that has 5-year timeframe as you can with a portfolio with a 20-year timeframe. This is because the longer the time you have, the more ups and downs you can survive. Despite the drastic fall in 2008 with the financial crises, the markets have since recovered and hit new highs. But if you only have 5 years until retirement, in 5 years time the market could be at a bottom.
Just because you make more money does not mean you can take more risk, but it does give you more capacity to take on risk. This means that even if you do incur a loss, you can still take the loss compared to someone else that makes less money than you do. A higher income also means you’re able to contribute more to your investments, if you control your expenses that is. Those are a couple reasons why income level is a factor in determining risk tolerance.
Investment knowledge and experience
This is also related to your risk capacity. If the market starts falling against you and you have no idea why, then it’s a lot scarier than someone that understands that the market is falling because of financial figures released by the company or the Federal Reserve have hurt company XYZ’s next quarter sales.
In terms of experience, the more ups and downs that you experience, the more you get used to how the market works. Sure not everyone is used to drops like what happened in 2008 not even the best fund managers in the world knew what hit them. But, if you have experience dealing with market drops you’ll be able to react quicker or adjust accordingly even when the times are tough. Experience will also reveal opportunities instead of making it seem like the world is ending, even though it seemed like the world was ending back in 2008.
Types or risk: Liquidity, market, and inflation risks
So what are some of the risks involved? To name three there are liquidity, market, specific and inflationary risks.
Liquidity risk means that you could be invested in something that is illiquid, meaning that it cannot be sold for cash very quickly. A good example is real estate, you can’t sell your house overnight. Other examples include art, coin collections, and over-the-counter (OTC) stocks. Stocks for the most part are pretty liquid however as you can sell the stock and simply wait for it to settle which takes three business days after the trade is placed or “T+3” as it’s called.
As the name suggest, market risk also known as systematic risk, is the risk that the entire market may fall and will take all of the investments that you own down with the trend. This type of risk cannot be diversified, as all stocks in a market will fall so regardless of your diversification efforts, all the stocks will be clobbered.
There is also something called unsystematic risk, which can be diversified away. Specific means that the risk is specific to the company or industry. So if a risk is company or industry specific, the key is to invest in companies that are in different industries.
This is one many people ignore but should be taken into consideration. Inflationary risk, also known as purchasing power risk, basically reduces what your money is worth every year. In the US, the average inflation rate is around 2-3%, so if you stick your money in a savings account that pays you 0.10% interest, you’re losing purchasing power with your money at a rate of -1.9~2.9% per year. So you might be reducing your risk by not buying riskier investments but you’re losing purchasing power every year.
Be realistic, does that risk profile really sound like you?
So after completing the questionnaire and having it determine your risk profile, or investor profile as it sometimes called, you’ve been given a general idea as to what kind of investor you are. There are a variety of names for the different levels of risk. At Freedom Nova, I’ll be using 6 levels, which are secure, very conservative, conservative, balanced, aggressive and very aggressive. I’ve made pie charts to illustrate what this looks like and have excluded secure as secure investors are supposed to invest completely in cash or cash equivalents at least in my mind. Please bear in mind that these asset allocation percentages can also vary depending on whom you work with, so think of these as ballpark figures.
Each pie chart has a breakdown of the assets you should own, yes it’s vague but it gives you the idea. This is because even within equities (stocks) there are stocks with different levels of risk involved. For example, a blue chip stock that has been around for a hundred years and pays a healthy dividend is likely less risky compared to a growth stock that had an IPO (Initial Public Offering) last year, meaning it went public last year, and has yet to show a positive year.
Take a look at those pie charts and if you are a Balanced investor, are you willing to invest 55-60% of your money in stocks? Think larger terms for example 3 years worth of salary. If you had a portfolio of that size, would having 60% of that money in stocks make you uncomfortable? Can you bear watching stocks tank and still sleep at night? If not, you should rethink and reassess your risk tolerance.
On the other hand, if you don’t feel anything at all and want to take more risk then you should reassess as well. However, there’s a difference between being willing to take more risk and being reckless. If you’re going to take more risk you should look back at some of the factors behind assessing your risk tolerance, which again include: age, timeframe, income level, and investment knowledge and experience.
Different investments carry different levels of risk
This risk pyramid shows different investments classified into high, medium, and low risk. When I go into the actual asset allocation of a portfolio, I’ll break this down further but the purpose of this risk pyramid is to show you where each investment roughly stands.
Don’t throw your risk tolerance out the window (don’t time or chase the market)
This happens more often than not. You do the questionnaire and based on your findings you come out as a Balanced Investor. 6 months into your investment plan the stock market takes off and you’re kicking yourself that you didn’t invest more money into the stock market. Suddenly you’re an aggressive investor because you think you can have this figured out and you’ve jumped from a novice investor to a sophisticated investor because you’ve read a few books and some blogs (clearly not this website).
A month after you’ve switched to being an aggressive investor, the market tanks and you’ve lost 15% of your portfolio. Had you stayed as a balanced investor, that loss might have been 10%. Now you’re a little scared of the stock market because just like Uncle Joe said, it’s like gambling because anything can happen. So you reassess your risk and realize that now you’re a Conservative investor and adjust your asset allocation accordingly, taking the losses. Six months later, the market recovers to the original level and now you’re kicking yourself even more.
Without question, this type of “investing” is dangerous. This is actually speculating and you’re trying to time or chase the market whereby you let the market dictate your actions. If this is your personality, you need to bear down and stick your money in a mutual fund or better yet talk to a financial advisor that will talk some sense into you when you’re on the verge to make the change.
As you read this, you’re probably saying, “I would never do that!” We all say it, I’ve said it before too only to sell a stock too early or to take a loss too early. Money and psychology can do funny things to us.
Don’t assume you’ll have the same risk tolerance forever
Despite what I just said, I don’t want you to get stuck into thinking that your investor profile will never change. If you’re a balanced investor now, you likely won’t be a balanced investor forever. As you age and gain more experience your investor profile could become more or less risky. Usually the trend is less risky as you want to reduce the risk as you go into retirement. This is because many investors tend to sell off portions of their investment portfolio to fund their retirement. At Freedom Nova, I want you to work on creating an investment portfolio that lasts forever meaning your goals will be bigger. Read about the Magic Number here to see what I’m talking about.
Risk of your portfolio can change if you don’t pay attention
You can’t set your investment portfolios on auto and expect everything to take care of itself. That’s why fund managers get paid the big bucks, to monitor the portfolio and make decisions accordingly. Companies, industries, countries, and you can change over time. That’s why you should be reviewing your portfolio regularly, I’d say at least twice a year to see if a stock has taken off and completely taken your equity portion of the portfolio over it’s threshold.