Assessing your tolerance to risk

Just as everyone will have a different objective for retirement income, they also have their own unique personality and financial circumstances.

Your personal attributes will help to influence the investment strategy you choose to pursue. They will determine whether you have the personality and financial ability to adopt an aggressive investment strategy that is subject to considerable volatility or whether you should take a more conservative approach.

Your first challenge is to find a way to determine your tolerance to risk and volatility.

Risk and risk tolerance are often discussed when the topic of investing arises but they are seldom defined and even then the definitions vary. Before you can begin an investment plan, you need to know what kind of an investment profile you have.

Assessing your tolerance to risk is the first step you need to take before you make any investment decisions.

Factors to consider

 The risk tolerance among individuals will vary based upon their age, experience, net worth, risk capital and even their personality. Each of these elements must be weighed and factored into the final decision. The question becomes how to weigh and factor the elements.

Age

It is generally perceived that a younger investor has a long-term time horizon in terms of the need for investments and can take more risk, while an older individual has a short investment horizon and should take less risk, especially once they have retired.

However, there are a number of other considerations that come into play. Just because you are 65 doesn’t necessarily mean that you must shift everything to conservative investments.

Investment Objectives

 Your investment objectives must be considered when calculating how much risk can be assumed.

 Are you seeking long term growth; are you seeking income; or are you seeking to protect what you have, even if the possibility of earning a reasonable return is remote? Each of these three simple objectives would require different approaches to investing. It is important to know what you are trying to accomplish.

Investment Experience

Your level of investment experience is an important consideration in determining risk tolerance. Are you relatively new to investing or have you had considerable experience? Do you rely on your advisor for recommendations or do you research your own investments? Have you had experience with a variety of different investments or has it been limited to mutual funds and GICs?

Net worth

Risk capital is money available to invest or trade that will not affect your lifestyle if lost. High net worth investors may have set aside enough capital to ensure a comfortable retirement. If that is the case, the portion of their investments not required to generate retirement income (their risk capital) can be allocated to higher risk investments.

All too often, however, those with low net worth can be drawn to riskier investments because of the lure of large profits that can seemingly be attained quickly and easily. They believe that these investments can be their ticket to financial success that would otherwise be impossible. When the losses mount, the disillusioned investor has fallen even farther behind in his quest for a comfortable retirement.

Personality

 While factors such as our age, investment experience and net worth are easy to measure, each of us has our own personality. There are high net worth investors who may be able to afford losses in their portfolios in the pursuit of higher returns but that approach conflicts with their personality.

Your personality is a major factor that must be considered along with the more measurable aspects of your investment profile.

 Kinds of risk

Many investors see risk only in terms of safety of their principal. While that is certainly one risk, there are others; including re-investment risk, inflation risk, and market volatility.

Re-investment risk

 Almost no one thinks of a guaranteed investment certificate as having any risk associated with it. After all, the principal is guaranteed, usually up to $100,000 per person. What you don’t know is the interest rate you will be able to earn when that GIC matures and you go to re-invest your money.

 It is a forgotten risk but over the past twenty-five years investors have been re-investing their GICs at lower and lower rates. Those who assumed rates would remain constant miscalculated badly. Yes, their principal is intact but their financial plan may have fallen behind where they had hoped it would be.

Inflation risk

Inflation slowly erodes the purchasing power of a dollar. Each year costs go up and if your investments are not compensating for that increase you are going backwards. If you go backwards long enough, your investments will no longer generate enough income to satisfy your needs.

The challenge comes in determining how much to compensate for this decrease in purchasing power. Over the past twenty years inflation has averaged just over 2% per year in Canada but it sometimes rears its ugly head at an inopportune time. In the period from 1973 to 1982 the inflation rate in Canada averaged 9.6% per year. A basket of goods that cost $100 at the beginning of that period would have cost over $230 ten years later.

We have been fortunate in Canada during our lifetime. Many countries have experienced hyperinflation when their governments continue to print money in extreme amounts even when there has been no corresponding increase in economic activity.

The most notable example is Germany in the 1920s when inflation destroyed their currency and the exchange rate between the mark and the US dollar reached a ratio of 42 trillion to one! It didn’t matter if their principal was safe because it no longer had any value.

That is an extreme example but governments worldwide have been printing excessive amounts of money over the past few years rather than cutting back on government spending. The charge was led by Ben Bernanke, head of the US Federal Reserve. These policies have increased the risk that inflation could slash the purchasing power of your investments.

Volatility risk

Very few people, if any, have lost all of their money by having it invested in a properly diversified portfolio of stocks and bonds. However, the values will fluctuate up and down, sometimes severely, and it can happen that just when you need your money the most, it is at a low value.

The conundrum is that investors need to accept more volatility in their portfolios to offset re-investment risk and inflation risk. The challenge is to strike an appropriate balance, but before that can be done it is worthwhile to learn more about volatility and how you can expect your portfolio to act.

Understanding volatility

One of the issues that many investors struggle with is their expectations.

When they have a financial plan drawn up and one of the underlying assumptions is that their investment portfolio will achieve average annual returns of 6% over the long term, then that is often what they expect . . . every year.

Nothing could be further from the truth. The last thing an investor should expect is that returns on their portfolio from one year to the next will be even close to the long term average that they are seeking. Over the long term it will tend to average out but on a year-to-year basis it is a roller coaster, particularly in the equity markets.

The roller coaster

 From 1900 to 2011 the average annual increase in the Dow Jones Industrial Average, excluding dividends, was about 8% per year. Immediately, that is what many investors expect from the equity portion of their portfolio.

Once dividends are factored in and management fees deducted, it seems like a realistic number.

 The actual experience is far different. It can be a terrifying roller coaster ride for investors. Even investors who are more realistic can be surprised by short term results. Take, for example, the investor who expects the long term average performance of his equities to be about 8% per year. He considers himself to be knowledgeable and is aware of volatility, expecting his portfolio returns to fall between 4% and 12% per year most of the time.

 He also realizes that his equities may show significant declines from time to time.

 The reality is that the Dow showed gains of between 4% and 12% per year about 12 times in the past 110 years. In the other 98 years, the return was either below 4% or above 12%. In fact, while achieving an average annual gain of about 8% per year, the Dow Jones Industrial Average would have handed investors losses in over one-third of those years . . . so much for expectations!

 While the average annual return (about 8%) is what many investors expect on a yearly basis, that kind of return without volatility exists only in our dreams. It is easy to see that returns are usually significantly higher or significantly lower than the average returns that so many investors expect.

 The graph illustrates the actual returns achieved by the Dow Jones Industrial Average in each year since 1900. Few people realize that it is those wildly random returns that, when averaged together, result in that 7% or 8% that we all crave. Two words can be used to describe the returns provided by an investment in the equity markets. They are: inconsistent and unpredictable.

There is one way to almost completely eliminate volatility and that is to accept returns on your investment that approach zero. It is not a particularly attractive alternative, especially when you see what inflation does to your purchasing power over time.

Finding the compromise

 Can you accept that one out of every three years will generate losses on your portfolio? Can you accept that some of those losses will be greater than 20% or even greater than 30%? That is the history of the Dow Jones Industrial Average and this average includes primarily blue chip companies.

Investing in smaller companies or speculative stocks creates even more volatility.

Clearly, there has to be a compromise between taking too much volatility in the pursuit of high returns and accepting zero returns for the sake of eliminating all price fluctuations. Neither of these conditions is acceptable, nor are they likely to help you fulfil your financial objectives.

It is important to consider both emotional and financial factors when determining your ability to tolerate risk. Some individuals may have a personality that enjoys the adrenalin rush of an aggressive investment strategy but that strategy may be inappropriate given their financial circumstances.

Finding your own unique compromise is the key. How much volatility can you accept in your portfolio?

Part of the difficulty is that there is no readily available standard against which investors can measure themselves. What is acceptable and what is excessive? Given that shortcoming, when investors attempt to define that tolerance, many have nothing to rely on but their own intuition. They have an idea that a balance needs to be struck but where should the line be drawn?

While intuition should play a role, we have seen a number of other factors that come into play. Determining the impact of all these factors is a challenge.

 Assessing your investment profile

When completing an account application form, many investors will defer to their financial advisor when trying to determine what their profile might be. In their mind, the advisor has seen numerous investors over the years and therefore should be able to tell them where they fit in the overall scheme of things.

At other times, investors don’t attach as much importance to this subject and provide a response without giving it as much thought as they should.

The investment profile provides the blueprint of how a portfolio should be constructed. In other words, it provides the guidelines for an appropriate asset allocation. Doing a good job in this area improves the chances that an investor will be happy with their portfolio.

If you are unsure of where you fit and want a quick way to evaluate your holdings, you can use the following rule of thumb. The total allocation to fixed income should be approximately equal to your age. If you are 60 years old, then approximately 60 percent of your portfolio should be allocated to bonds, if you are a moderate investor. The remainder of the portfolio could be allocated to other asset classes. It’s not perfect but it is a reasonable compromise.

 Solutions

A better solution is to complete an investment profile questionnaire. The range of questions can vary widely from one to another but they all help to provide investors with somewhat objective guidelines for categorizing themselves.

 Some ask questions about how investors might feel if a specific event occurred in the future, how they felt when a specific event occurred in the past or what action they might take should a specific event occur. These are more emotion based questionnaires which are very subjective. A more fact based questionnaire may be easier to answer accurately.

You can try a couple of different self-evaluation reviews to come up with the most accurate profile possible. If you are working with a financial advisor, most will have access to at least one such questionnaire and possibly more.

Many mutual fund companies also provide risk tolerance questionnaires on their websites. With all of these tools, there is no reason why a diligent investor should not have a reasonable idea of what their investment profile is.

Summary

It is important for you to review your goals and objectives every couple of years. If these goals and tolerance to risk have changed, then so has the ideal asset mix for your portfolios. We all get older every year and even if nothing else changes, that does.

Notes:

Factors used in assessing your tolerance to risk include your age, investment objectives, investment experience, net worth and personality.

  • Various kinds of risk that can threaten your portfolio can include capital risk, re-investment risk, inflation risk and volatility risk.
  • Many investors only consider capital risk.
  • Over the past 110 calendar years the stock market in the United States has handed investors negative returns in over one-third of those years.
  • Consider using an investment profile questionnaire to assess your tolerance to risk.
  • The make-up of your portfolio should reflect the amount of risk you are willing to assume and not the returns you are hoping to achieve.

NEXT: Investment Planning - Diversifying Your Portfolio

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