By Michael Leanza, CFP®
If you work with a financial advisor, have you ever discussed risk tolerance? Risk tolerance can be defined as the degree of variability in investment returns that you’re willing to withstand.
In other words…how much money would you be willing to lose before you begin to panic?
Some advisors gauge a client’s risk tolerance simply to comply with regulatory requirements. Others discuss it with clients because they really want to understand your comfort level with a specific investment.
Yet many financial advisors ignore the topic entirely with clients. Why would such an important issue be ignored you ask? Well, it has to do with emotion. How we feel about taking on risk might be swayed by how the markets are doing on a particular day and not how we truly feel deep down.
It’s human nature. Sometimes we follow our hearts and not our heads. When markets are soaring, we suddenly feel like it’s a good time jump into the pool. Conversely, when markets are declining, we pull back on the reins. These are not objective measures of how much risk we’re willing to accept. They are only emotional reactions to what’s going on around us.
So how do we uncover the “real-deal” about risk tolerance? A good start is to know your “panic point” or what kind of loss you can sustain before you begin to panic. As you would imagine, this is highly individualized. Here is a list of things for you to contemplate when evaluating your own “panic point”:
- How much loss can I sustain in my investment account before I will begin to panic? Knowing this will help your advisor build in the proper ratio of lower risk to higher risk investments to help maximize gains and limit declines.
- What % return do I expect from my portfolio over time? Looking at your investment returns over shorter periods of time (1 year, 1 quarter, 1 month) means that you’re likely to see greater variations in your returns. A more true indication of performance (a normalized average) comes over a full market cycle (typically 4-5 years).
- What motivates me? Ask yourself what you’re really out to achieve with your portfolio. Is this money you will need in the next 5 years? Not knowing can cause you to stumble and lose focus.
- Do I have any false motivations?These may include:
- “My co-worker seems to have done well with XYZ fund. I think I should invest in that.”
- “I’m motivated by large gains” (As long as you are OK with the greater risk you may need to take on to achieve them)
- “I’m motivated to avoid large losses” (As long as you are OK with slower growth over time that gives you stability)
- “I want to have stock market-like returns” (As long as you are OK with the greater swings often seen in equity markets)
- “I prefer investments with guaranteed returns that allow me to sleep at night” (As long as you are OK with the restrictions they may have around liquidity)
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. No strategy can assure a profit or protect from loss.
Tracking # 1-249432