Writing my monthly column in the Tacoma News Tribune I’m often challenged to keep it to my allotted 800 words.
For my March column, covering risk tolerance and its connection to the actual level of risk in a personal investment portfolio resulted in a lot of overflow.
Here are five more topics I think are meaningful in any discussion of evaluating risk tolerance and managing investment risk.
Your investment success isn’t determined solely by returns of the marketplace. It is dictated by your response to the returns of the marketplace. Therefore, your response to markets is a form of risk just as the actual returns of markets represent forms of risk.
Just as battles aren’t won or lost on the field of action, they are decided in the planning and the adjustments made to correct course along the way. When your plan includes an understanding of risk tolerance and you invest with some sense of what to expect on the battlefield (so to speak) you’ll increase the likelihood of reaching your goals.
If you could quantify your risk tolerance and compare it with a similar assessment of the level of risk in your investments, you would likely get closer to the point where you could experience risk with less need to “just do something.” You would have some alignment. Some logic or reason to justify the means to an end.
We have a had a recent breakthough in the evaluation of risk tolerance and portfolio risk. We now use a technology called Riskalyze. It is based on a Nobel Prize winning theory of behavioral economics. Riskalyze creates the link between personal risk tolerance and risk attributes of the investment portfolio.
Regardless of how much you push for higher returns or hunker down for low fluctuation of your balance, you shouldn’t take any more risk than you expect to be reasonably compensated for. In many cases, how well you are compensated for the risk ultimately decides your level of comfort or regret for having taken the risk.
Using portfolio modeling tools we can produce investment mixes that demonstrate reduced risk and, in many cases, increased return by optimizing the balance of return-seeking attributes and risk management in the portfolio. Of course, even the best resources only allow optimization based on past conditions. It’s a much more difficult task to identify the most optimal portfolio in advance when the market leaders and favored asset classes continually shift.
Using some scientific elements to measure risk tolerance and its associated behaviors can be useful, but sometimes, it’s more important to know how people developed their risk tendencies. Was it acquired through family osmosis? Learned as a result of previous decisions around life and money? Or evolved over time shifting along with a general sense of financial security.
When homes are building equity and markets are climbing, there is a natural climb in perceived risk tolerance. Whether it has staying power is only tested upon the reversing trends.
People define risks in many different ways.
Risk is overly concentrating your financial security in one investment or income source. It is risky to have only Social Security to fund retirement. It can be risky to own only rental property … or too much stock in your employer. It’s risky to only own government bonds that may lose pace to inflation.
Is it risk if the asset can be expected to return to previous value and perhaps exceed it within a few years? Some speculative investments do go to zero but permanent loss of capital is not likely in a diversified investment approach.
Do your investments pass the pencil test?
Individually, a pencil is easy to snap in half. Collectively, however, it’s impossible to snap handful of pencils bound together. This is the effect of having a diversified portfolio that spreads risk while still be positioned for long-term growth.
Many people are statistically challenged
Abundant research has demonstrated how the great majority of people rate themselves as better than average at just about any task or topic. Of course, this is statistically impossible. A similar misread occurs when judging the probability of outcomes. What events are more likely to happen than others? This gets particularly complicated in the investment world where uncertainty and luck participate in the outcomes.
But the real challenge is that even upon seeing evidence that counters initial assumptions or tendencies, many people don’t allow the evidence to change their first impression. Facts get ignored, or at least outweighed by feelings. And this can lead to a worse outcome than simply being ignorant or unknowing of the facts.
Having a comprehensive financial plan can improve the understanding of statistical analysis, probability of reaching your goals and positioning for adequate investment returns.
With the caveat that no single source is adequate to measure your risk tolerance, here are a couple questionnaires that can at least provide some framework for that task.
Use these results in conjunction with a financial plan to determine how much risk is inherent in your investments and your financial life.
A financial plan becomes the tool by which to evaluate how you think about risk. It gives you a sense of where you are and what you are trying to get to.
With a plan in place, you can then determine how to build an fitting investment strategy. Document this strategy with an investment policy statement that puts into writing how you will manage the ongoing mix of asset classes, how you will rebalance and measure performance.
With an IPS in place, you have the guidance for how to implement the investment strategy in a cost effective way.
The package of financial plan and investment policy then given you the framework to re-evaluate when your life changes, your goals change or you develop a new understanding of your tolerance for fluctuations in markets.
By Gary Brooks, CFP — Brooks, Hughes & Jones Wealth Advisors — Tacoma, WA