Risk Tolerance: 4 Issues with Key Questions to Discuss with Your Financial Advisor
An investment of any type carries some level of risk. How can you better understand your tolerance for investment risk? More important, how can you improve your tolerance for acceptable risks while increasing your awareness of unnecessary risks?
There’s a lot of conventional opinion about how to understand your risk tolerance. Here are four issues with common interpretations of risk, risk tolerance, and understanding risk tolerance – and four related “sharpened” questions to help you think more clearly about wealth and the risks you take.
Risk Tolerance Issue #1: The Relevance of Personality to Risk Tolerance
A common assumption about risk tolerance is that your risk tolerance is significantly influenced by your personality – for example, that someone with a “Type A” personality will tend to take more risk than someone who is “Type B.” Could a personality test help you understand your risk tolerance better?
Sharpen the question: Should financial planning and investing be influenced by someone’s personality, or should the advisor help educate about what the best plan should be and try to adjust or educate about personality so it doesn’t get in the way?
Risk Tolerance Issue #2: The Relevance of Income to Risk Tolerance
A common assumption about risk tolerance is that a steady job or higher income makes it more likely that your risk tolerance will be higher. For example, a 10% increase in income has been linked to a 0.9% increase in risk tolerance. How is this assumption relevant to you?
Sharpen the question: Is your investment aligned with your budgeting and expenses, so that you are not investing money you need to pay those expenses? When money in investments needs to be harvested to meet living expenses, the risk comes in the probability that the money will be there when you need it. If the money that you need soon is allocated to investments where patience is required, you have a mismatch of income and risk tolerance.
Risk Tolerance Issue #3: The Relationship Between Investment Period and Risk Tolerance
A common assumption about risk tolerance is that a longer period of investment typically enables your risk tolerance to be higher – because when the market fluctuates or dips, your investment – and you – have more time to recover. How does this assumption actually apply to you?
Sharpen the question: Benjamin Graham said that markets are like voting machines in the short term (moved by fear and greed and popularity, etc.) and weighing machines in the long term (determined by real worth). If longer time periods allow a sound investment to recover, whatever the down-market cycle’s length, what is the maximum allocation you can invest and not need to touch for seven or eight or ten years?
Risk Tolerance Issue #4: The Relationship Between Risk Tolerance and Emotional Reactions to a Big Drop in an Investment’s Value
A common assumption about risk tolerance is that you should: imagine having made a 10-year investment that then drops to half its value in year 2; ask yourself whether that would make you considerably worried, reactive, or anxious, and; take a “yes” answer to mean that your risk tolerance is probably on the lower side.
Sharpen the question: What is the proper response: surrender to your emotions or try to build a plan that allows you to ignore the short term while focusing on the long term? Volatility is a red herring when it comes to risk, and it’s important to think about risk as Buffett and Martin Whitman have defined it: the permanent loss of capital. Here’s the question: have you gotten to the point where you’ve lost that money for good? If a stock goes down and you don’t sell it and it recovers, you haven’t lost money.
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