Wait a minute…. You know I’m setting you up. Really, it’s not a trick question, but calculating your portfolio risk tolerance level is a much more complicated question than you might think.
Assessing your risk tolerance is a common occurrence when opening an investment account. You answer a few questions, and then you are told that you are aggressive, or moderately conservative, or some other level that determines how your portfolio is allocated. Allocation is the blending of different asset classes (think stocks and bonds) to create a portfolio that has both a projected return level and a level of risk. Once that risk tolerance level has shaped the investments in the portfolio, too many times, that’s the end of it. But risk tolerance is much more complex than that, and I want to give you three things to think about to help your calculated risk tolerance match your true risk tolerance.
First, one of the primary considerations in risk tolerance is time horizon. However, it’s likely that you have different investment accounts with different time horizons. For example, if you are saving for a vacation next summer, saving for your thirteen-year-old child’s college tuition, and saving for your retirement in thirty years, you have three different risk tolerance levels in those three accounts. They shouldn’t be invested the same way, with the vacation fund in really safe items (like CDs) and your retirement account invested more aggressively for growth. When you have a short time horizon, you don’t have time for investments to recover in a stock market crash the way you do if you don’t need the money any time soon.
Second, your emotions will impact how you complete your risk tolerance form. If you are feeling particularly optimistic the day you fill it out, you may be categorized as more aggressive than you really are. If you are sad, you may be more conservative. As a result, avoid completing risk tolerance forms at times of high stress (especially after deaths or divorce). Additionally, revisit your risk tolerance form every year or two to be sure it is still appropriate.
Finally, remember that it’s pretty easy to think it will never rain again when the sun is shining. When the market is going down, you have to expect your investment portfolio to be in the same positions you selected when the market was going up. Even if you actively manage your own money or use a portfolio manager, there is no guarantee that either of you will see the market decline before it happens. Odds are, you won’t. Additionally, when markets are really bad, some of the tools used to diversify your portfolio don’t work as well, and declines can be pretty brutal. (I’ll talk about that issue in a different post.) Of course, with good diversification in index funds, the market is most likely coming back and will go on to set new highs. But you must have the time and the nerves to see it through. Do not overestimate you ability to handle jaw-dropping market declines.
Risk tolerance forms are useful, but they have limitations. If you haven’t done it recently, look at your risk tolerance level, be sure you understand the implications of potential return and potential risk, and decide if you are still invested in the way that will help you prosper!
Disclaimer: Remember this is educational, not investment advice. Past performance does not indicate future performance. Investing is risky, and you can lose money.