Finding Your Financial Risk Tolerance
Every investor should know his or her financial risk tolerance. Most people think of risk tolerance as how aggressively they want to invest, but in reality, it’s how much volatility you can emotionally withstand before you start to panic.
To determine your true risk tolerance, it’s also important to understand your risk capacity, or how much risk you “need” to take in order to reach your financial goals. Combining these important factors helps you determine how much risk is the right amount for you when it comes to investing.
You may think you want to take an aggressive approach to investing – you’re a risk-taker in your everyday life, enjoying the rush that comes with skydiving or extreme sports. But often times, that risk tolerance changes when it comes to your hard-earned money. How will you feel when the market drops and you watch your investments lose value on paper? Will this situation make you want to jump ship and change course?
Another misconception when it comes to risk is that you fall into one of three categories: Aggressive, conservative or moderate. But this is a narrow view of risk tolerance, and in our experience at TrustCore, most people fall somewhere in between.
The team at TrustCore created this guide to highlight some of the key components in determining your true financial risk tolerance so you can better understand where you really fall on the spectrum.
A key aspect of your risk tolerance is how much risk you need to take to get the desired returns necessary to meet your long-term goals. For example, if you only need a 4 percent annual return to meet your goals, there’s no reason to put your financial future in jeopardy by investing aggressively for a chance at a 9 percent return.
When finding your financial risk tolerance, think about your financial needs, especially your long-term needs such as in retirement. How much income will you need each year in retirement to accomplish the lifestyle you want, be it traveling, maintaining your current lifestyle while no longer working or remodeling your home? What size nest egg do you need to provide that income?
This number should then be weighed against your emotional risk tolerance. Ultimately, it won’t do you any good to invest aggressively for a 9 percent return if every time the market hits a bump, you panic and pull all your money out of the market. Selling during a downturn is one of the most common ways investors derail their long-term investing returns. This is why it’s so important not to invest more aggressively than you can actually handle. The key to investing is being able to stick to your long-term strategy through the ups and downs.
Another factor that plays into your retirement needs and risk tolerance is your health and longevity. What many people don’t consider when thinking about health and longevity, however, is how longevity impacts your capacity for risk. Naturally, the longer your retirement is expected to last, the more money you’ll need to sustain it. If you expect your retirement to last for more than 30 years, you’re still a long-term investor even when you retire. You may still need some growth investments in your portfolio to help you keep up with inflation.
At TrustCore, we like to look at financial risk through the lens of, “How long am I investing for?” If it’s decades in the future, you may want to take a more aggressive approach.
Age is a common basis for risk tolerance assessments. The theory is simple: A younger person has a higher risk tolerance than an older person because the younger you are, the more time you have to make up for market downturns. As you get closer to retirement, on the other hand, your portfolio may not be able to afford to take so many swings because you have less time to recover financially.
What a solely age-based risk tolerance assessment is missing is that not everyone of the same age is in the same financial situation. A 50-year-old business owner in Tennessee, for example, may have a vastly different risk tolerance than a 50-year-old W2 employee working for a large company. A more accurate way to factor age into your risk tolerance is by determining how far away you are from when you expect to start living off your portfolio for income.
As you get closer to retirement, your risk tolerance often decreases because you can’t afford for your portfolio to decline in value right when you start withdrawing. This is why many people start to taper their portfolio risk when they’re within five years of retirement. But, as mentioned above, this doesn’t always make the most sense.
So, when determining your financial risk tolerance, rather than focusing on your age, think about the age you want to retire. How many years do you have between today and that age? Use this number to determine the level of risk you can take with your portfolio.
Insurance is an important element of any financial plan. The right insurance can help protect both you and your loved ones from financial loss. There are many types of insurance and the type you need will likely change throughout your life.
Your level of insurance coverage can also impact your financial risk tolerance. The more comprehensive your insurance coverage, the greater financial risks you may be willing and able to take.
You can also view insurance through the lens of guaranteed income in retirement. The more guaranteed income you can amass during retirement, whether through Social Security or a pension, the more flexibility you’ll have with your other investments.
For example, one reason people who are still working can afford to take more risks with their investments is that they know their daily living expenses will be covered by their paycheck. You can effectively create this same scenario for yourself in retirement by creating a stream of guaranteed income to cover all or most of your daily living expenses. This will allow you to have a greater tolerance for risk in other areas of your portfolio.
There are additional considerations business owners should take into account when determining their financial risk tolerance. Many business owners have a tendency to invest primarily within their own industry. This makes sense, given you likely know your industry well and can easily identify good financial opportunities, but this can also increase your financial risk. Anytime your portfolio is too heavily concentrated in a given industry, sector or company, you increase the risk that something could happen to that industry or company and negatively impact your portfolio.
Business owners should pay careful attention to any areas of concentration within their portfolio. This holds true for industry exposures as well as regional ones and even your own company. A large percentage of your net worth is likely tied up in your business. Often times, business owners want to reinvest a lot of their own resources into their company, but it’s important to weigh the benefits of doing so against the risks of being under-diversified.
As a business owner, you should also pay careful attention to your own liquidity. A rule of thumb for most investors is to keep at least six months’ worth of living expenses in cash or cash equivalents where it can be easily accessed. For business owners whose expenses often include the capital needs of their business, the size of an emergency fund can be quite large. Given this, talk to a financial advisor to see if diversifying your emergency fund with a few investments rather than only cash makes sense for you. While doing so would increase your overall risk, as all investments have some risk, it could also prevent you from leaving a large sum of money sitting in cash and earning less than the annual rate of inflation.
There are many online risk-tolerance tests you can take. A quick Internet search and you’ll find everything from a simple five-question survey that will lump you into one of four categories (conservative, moderately conservative, moderately aggressive, aggressive) to longer 20-question tests that try to put you on a spectrum of conservative versus aggressive. However, no matter how many questions or details these tests ask, they typically fall short in the same way. Remember, an algorithm is trying to categorize you based on pre-built assumptions. None of them treat you as an individual, because they can’t incorporate your personal needs.
Take, for example, the common question of, “Would you rather have a sure gain of $500,000 or a 50/50 chance of getting $1 million or nothing?” The answer to this depends on the rest of your portfolio, your financial situation, your family’s needs and many other aspects of your situation – all of which can change over time.
A real-life financial advisor can take a more individualized approach to risk tolerance. Unlike an algorithm that can only think in pre-programmed scenarios, a human being can incorporate the many facets of your unique situation into creating a risk tolerance profile, so these tools are used as part of the puzzle.
At TrustCore, we believe that financial planning should be a holistic process, taking every detail of a client’s situation into account.