THE IMPORTANCE OF KNOWING YOUR RISK TOLERANCE LEVEL
There are no activities that are completely risk free. Whether a person decides to eat, drive or sky dive, there is some level of risk involved. The same is true of investing. Every investment has its own type and level of risk. An individual’s risk tolerance — the level of risk they are willing to accept in exchange for potential reward — helps determine which investments they will be most comfortable with in both good times and bad.
In fact, the topic of risk tolerance has taken on renewed interest with the world’s financial markets dropping significantly thus far in 2022.
Risk Factors Versus Tolerance
An obvious component of investment risk is the potential for an individual stock to lose value. Casting the net further, one can see that the entire economy souring is yet another risk for investments. These risks can be further compounded by any number of events that impact the value of the investments in a portfolio.
An investor’s ability to tolerate these risks is incredibly personal. It is not only influenced by their emotional tendencies and beliefs around money, but also impacted by their personal situations. Factors such as an investor’s age or time until retirement, along with major life events such as marriage, divorce, or having a child can all impact an investor’s risk tolerance and require periodic realignment of their investments.
Investors are people and, thus, emotional. This can be a drawback when it comes to dealing with investment risk, because when an investor reacts emotionally to a potential financial threat, they very often make decisions that worsen their position rather than improving it. If an investor (and, ideally, their professional advisor), can better understand his or her individual risk tolerance, it becomes possible to create a process for dealing with financial threats no matter how life changes and a portfolio performs.
As global equity markets rise, few investors consider the impact of risk. Only when a correction or bear market occurs do investors begin to shift their focus to risk. Because returns don’t occur in a vacuum, it is essential to understand the various investment risks inherent in building wealth and analyze each investor’s ability to tolerate them.
Most investors have probably filled out a standard risk questionnaire at some point. Instead of attempting a self-assessment, however, a superior method is to remove the guesswork and align each investor’s portfolio with a technically assessed overall risk score. This is accomplished by using prospect theory, a Nobel-prize-winning technology that helps to quantify each investor’s risk tolerance into a simple risk number between 1 and 99. Based on an investor’s actual investable dollars and the way they answer quantifiable questions relating to their acceptance level over a six-month period, prospect theory uses percentages to quantify how comfortable each investor is with gaining or losing a certain dollar amount.
How Prospect Theory Works
The process begins by quantifying the amount of downside risk one can handle over a short period of time, such as six months. This is done by asking the investor to indicate, with a sliding bar, the amount they are willing to lose in exchange for a chance to gain a different amount. For example, would an investor be willing to risk an 8% loss for the chance to potentially gain 14%? The system will further clarify by turning the example into a dollar amount—for example, would an investor be willing to risk an $80,000 loss for the chance to potentially gain $140,000? The most impactful part of the exercise is when an investor’s current investments are stress tested to determine whether the asset allocation mix matches the risk tolerance and financial goals. Too often, the results are not aligned, and reallocation needs to occur.
Harry Markowitz, a Nobel Prize-winning economist, was once asked by the Wall Street Journal how he invests his own money. He replied:
“I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret. So, I split my contributions 50/50 between bonds and equities.”
Investors typically will tolerate additional risk when markets are rising and become overly risk-averse when markets begin to fall. Measuring risk tolerance during a bull market generally results in scores that are significantly higher than when risk tolerance is measured after a market crash. Financial advisors need to find ways to work around this bias to get a more accurate reflection of each investor’s true risk tolerance and prospect theory is a helpful aid in doing so.
Portfolio Risk Scores: COVID Drop in the Spring of 2020
The chart below may help readers quantify the difference between portfolios generating various risk scores (between 1 and 100, with 100 having the most risk). One can see that clearly here that the portfolios with higher risk scores lost more of their value during the COVID market pullback in the Spring of 2020. It’s crucial to comprehend the amount of risk, in actual dollar terms, that you are currently taking on in your investment portfolio. Understanding how portfolio risk can impact actual investment losses can help investors when setting target allocations, so they don’t overestimate their emotional ability to deal with losses in poor market conditions.
Finding A Dedicated Advisor
One of the most important value-added services an advisor can provide is ensuring that reason and discipline prevail over emotions such as fear and regret. Investors should endeavor to work with an advisor who understands that risk tolerance evolves over time and realizes that it is not enough to simply rebalance based on an initial risk assessment. Throughout the years of a relationship with an investor, the ideal advisor should periodically evaluate risk scores and match portfolios to the results.