Do you have a good understanding of your risk tolerance or capacity for investment risk? Most investors think they do, but this self-assessment usually involves only the calm and rational viewpoint. What about your tolerance for risk under stress?
The way you perceive risk is mostly a combination of DNA and the previous risky situations you have experienced in the past.
What is Risk?
Determining an appropriate level of risk is at the very core of financial planning. Yet many advisors and clients have a stilted perspective on this topic. The problem can be traced directly to an inaccurate definition of risk. Investment volatility or uncertainty isn’t risk; failing to meet your financial goals is risk.
Some advisors use risk questionnaires in an attempt to “measure” tolerance for risk. We stopped doing this a decade or so ago. To me, most of these questionnaires reinforce the wrong definition of risk. They allow investors to think they can achieve desired financial outcomes without much risk.
Understanding that risk and return are related is a critical component in developing a realistic goal-based financial strategy. Achieving your particular goals, and avoiding financial failure are the objectives.
Risk has multiple layers and individuals can have different risk capacities or tolerances for different goals. This type of mental accounting can be useful as it helps us organize important distinctions within an array of goals.
Risk Tolerance Should Relate to Achieving Outcomes
Think about your “risk tolerance” in the context of having a very serious life-threatening medical condition. Imagine your doctor handing you a risk tolerance questionnaire that connects different “risk” levels with particular treatments and probable outcomes.
On one end of the spectrum, the treatment is a baby aspirin with minimal risk and also low probabilities of success. Then on the other end are more serious drugs, therapy, and surgery with possibilities more positive outcome. If your survival is the goal, choosing some of the lower risk options may fall short of that outcome. In the end, risk is just about achieving the desired outcome and nothing else.
Until scary financial (or medical) conditions are encountered, risk seems conceptual and arbitrary. Only through personal, first-hand experience do you accrue knowledge of exactly how you will make decisions when things turn out differently than what you expected.
Part of the art of financial planning is guiding clients toward a level of risk that puts the attainment of their goals as a reasonable possibility, while not losing sleep over their portfolio. Most investors need somewhat higher levels of risk than they may like, but focusing on their ultimate goal helps keep everything aligned.
Choosing the low risk option and failing to meet your financial goal is actually the largest risk of all. Ready for a real conversation?