Perhaps the most critical decision you can make about investment management is how much risk to take. Once you have determined an appropriate level of risk, you can start making asset allocation decisions such as the percentage of your portfolio to be held in stocks. This analysis is vital to your financial success as asset class selection is the most significant factor in investment performance.
Unfortunately, most investors have little idea what level of risk is appropriate. Some common shortcuts used by financial advisers and laypersons alike only give you the beginnings of the knowledge needed to design an individualized investment strategy.
Often when investors design a portfolio, the first step is to fill out a risk tolerance questionnaire. They are filled with questions designed to determine your psychological propensity for accepting risk versus your desire for higher returns. What is your reaction when you lose money on an investment? How do you feel after you make a big financial decision, confident or anxious?
Once you complete the survey, you get a score that shows your investor pain-pleasure index. Those willing to accept the inherent wobbliness of the market as compensation for greater returns will get a higher score.
So what’s wrong with these tests? Nothing at face value.
Risk tolerance is a very important component in portfolio management and these tests can help define how you would react in a market downturn. Your money should serve you, rather than cause undue stress. The problem is that many individual investors and their advisers use risk tolerance scores as the sole determinant of asset allocation decisions.
These tests fail to consider the financial profile, financial goals and other risks of the client. By financial profile, we’re most concerned about your investible net worth and annual spending. It can show us whether you need to take very little risk to achieve your goals or whether you need to be more aggressive in your investments.
Someone with a $5 million portfolio and annual spending of $100,000 can invest conservatively to support themselves, regardless of their risk tolerance. If your portfolio value is closer to your level of annual spending, then you need to take greater risk to achieve your goals.
Financial goals, whether it’s buying a first house or moving up, paying for your children’s higher education, retiring at 65 in comfort, or taking a 12-month sabbatical from your career must be considered.
Imagine that you have incredible tolerance for risk and are in your 30s. Many cookie cutter risk profiles would put you in an aggressive investor category. If you’re planning on putting $150,000 down on a house within six months, the proximity of your goal demands that you take very little risk with those funds.
A client’s other risks particular to their situation, or endogenous risks, are often forgotten. Professional athletes are perhaps the archetype here. They may bring down millions a year, but their earning potential is unpredictable and its duration is short.
For every Elway who has built upon the financial base of a successful athletic career, there are scores who are bankrupt within five years of retirement. Entrepreneurs involved in serial business startups have a different risk profile than a 20-year employee of the federal government.
Whether you are working with a financial adviser or managing your own affairs, you must consider not only your risk tolerance, but also your financial profile, the proximity and nature of your financial goals, and the other risks in your life when coming up with an appropriate investment strategy. On its own, a psychological profile in the form of a risk tolerance questionnaire is woefully inadequate.
Dave Gardner, for the Daily Camera.