How we handle risk tolerance and daily decisions from the amount of speed we choose to drive our car down the highway to selecting health insurance coverage and deductibles, or even just getting on an airplane for the next family vacation are all examples of risk baked into our daily lives.
Your investment risk tolerance “DNA” is directly connected to your brain’s “pain threshold” to withstand market losses in extreme market conditions up to a certain point and not feel inclined to jump off the proverbial Wall Street roller coaster while in motion.
Risk tolerance can help you to decide specifically how much of your portfolio should be allocated to stocks vs bonds and cash and is the foundation of asset allocation. The recipe that is right for you based on your age, goals and time frame can help to determine your target return goal each year, as well as determine a range of losses you will accept when volatility spikes.
The time to complete a risk questionnaire and review your overall investment strategy should be a proactive, ongoing process throughout the year, like a diet or fitness regime, and not something performed as a knee-jerk reaction after a market crash.
Many (if not most) boomer and retired investors that meet with us for the first time for a consultation claim how they are “highly risk adverse and “don’t’ want to see half their portfolio lost in a crash” (who does?) but often times their investments do not match their goals while being either overweight stocks, cash vehicles, or both ends of the spectrum at the same time.
Managing your money to help meet your retirement and other long term goals while assessing risk, should not involve emotions, darts, tarot cards or luck, like playing a roulette wheel in Vegas where the “odds are on the house,” but should involve a scientific approach to determining your willingness and ability to tolerate risk while taking control of your own results and financial future.
In our experience and opinion, many advisors make incorrect assumptions on a client’s risk assessment because of age or career choice. We have many retired clients in their 70’s and 80’s who are invested in balanced 60/40 moderate-risk portfolios (stocks to bonds.) At the same time there are a few “Gen X” clients in their early 50’s who are more conservative, despite working in high-risk jobs such as commercial pilots and Emergency Medical Technicians.
You can study all the maxims and investment risk rules of thumb (such as invest your age in bonds) till the cows come home, but there is no proven direct correlation between your “investment IQ” capabilities to whether you are in Mensa, graduated from an Ivy league college or work as a surgeon or a Fortune 500 high tech engineer.
In our opinion, investors continually make significant misperceptions of themselves and their ability to emotionally handle risk or shoot for more risky products and strategies to help increase their income or returns due to greed or actual need. It seems that the smarter the person appears, the more likely they are to be overconfident with their risk-taking ability.
Having a misperception of your risk tolerance might also make you more vulnerable to scammers where you end up buying a complicated, high risk investment from a less than scrupulous advisor at a steak dinner.
Investing should not be a competition with your friends and neighbors at a cocktail party or on Face Book. You may recall running into a friend or coworker bragging to everyone on how their investment product is providing a highly attractive annual yield, but not tell you when their strategy went up in smoke and lost a third of principal in the past year.
We remind investors that it’s as important to consider the “return of your money” in as much the “return on your money” with each trade. Our favorite four-letter word is EXIT. No matter whether purchasing investment property, art, watches, jewelry, an automobile or stock, always consider valuations and liquidity (ease and access to your investment when needed.)
An investment advisors’ risk tolerance questionnaire can be a good start (albeit a very rough estimate) for clients to determine and target the appropriate levels of risk in their portfolios in three vital areas:
To calculate these risks, we question whether investor risk questionnaires are helpful.
In our opinion, many computer-generated risk questionnaires have hokey questions with vague numerical outputs and seem to be unreliable. It is sometimes just as difficult for advisors to just ask investors to benchmark their own risk tolerance because, as noted earlier, many of us are terrible at estimating our own risk and money management capabilities.
No matter what you may put down on a risk questionnaire, it’s only when the roller coaster turns sharply downward to 70 MPH after going up the hill 5 MPH as we experienced in March of 2020, do we truly know our own colors. There is a saying that stocks take the escalator up and the elevator down. Translation: the average investor may not be very proficient in completing a scientific assessment of his or her own risk level or taking an unemotional approach to volatility.
We believe that by combining fact-based questions along with a more scientific, goal-based approach to determining an investor’s willingness and ability to tolerate risk, can provide a smoother ride and a less emotional approach to short term volatility.
Our client’s risk tolerance questionnaire is on a one-page piece of paper with a focus on simplicity and imagery. The form considers the basics of an investors age, financial position and long-term goals combined with theoretical questions on how much they would like to earn on average annually along with how much they can stomach in losses in extreme market conditions. This then parlays them into the appropriate asset mix and strategic model portfolio selection.
The first course of action to invest, whether with a current portfolio, or if starting from cash, is to determine your risk tolerance and ensure that your asset mix of stocks to bonds matches up with your goals.
The second course of action is to ensure you are utilizing (and watching!) the appropriate benchmark. If you are in a balanced 60/40 stock to bond portfolio, your target benchmark would not be the DJIA Dow Jones Index (news) benchmark but a blended benchmark of various asset classes.
We utilize the method of Modern Portfolio Theory as our investment philosophy to position our clients into portfolios with the highest potential return over time for the lowest level of risk while helping to meet their objectives over time. Most important, we revisit a client’s risk form and goals periodically. Investing should not be a ‘set it and forget it’ approach.
You cannot invest directly in an index. Past performance is no guarantee of future returns. Diversification does not ensure a profit or guarantee against loss.
The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without Ulin & Co. Wealth Management’s or IFP’s express prior written consent.