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Financing + 1 more
Date: August 17, 2020

What’s Your Financial Risk Tolerance?

There are a million ways to invest your money. But the route you should take depends largely on your risk tolerance and your risk capacity.

Risk tolerance and risk capacity are two different things. And they may not be what you thought they were. While taking risks in life may have suited you well, when it comes to your finances, people tend to feel differently. You may have thought you were a high risk investor, but you are better off with a low risk portfolio allocation.

Understanding these two concepts is critical to reaching your goals. Determining the right risk for your portfolio is financial planning step 1.

What is Risk Tolerance?

Risk tolerance is the amount of loss you’re willing to take on in your investments. It’s how much your portfolio can dip before a knot starts to form in the pit of your stomach.

If you have a low risk tolerance, you tend to play it safe and invest more conservatively. If you have a high risk tolerance, you invest more aggressively.

It’s important to note that you may have a high risk tolerance in life, but a low risk tolerance with your finances. Even if you’re the living-on-the-edge type who likes to skydive and swim with the sharks, your natural instinct may be to avoid risk at all costs when it comes to your money.

Knowing your financial risk tolerance can help you create an investment strategy that doesn’t induce fear or panic when markets take a turn for the worse.

How to Determine Your Risk Tolerance

Risk tolerance isn’t cut and dry. It largely depends on your personality and comfort level.

Take 2020 for example. We were riding market highs in 2019, but now we’re in the thick of a bear market and accompanying recession. If current market conditions have you panicking and losing sleep at night, that’s a clear sign your risk tolerance may be lower than you thought.

Determining your true risk tolerance should be a more in-depth process than just answering a quick multiple-choice questionnaire. Discuss your concerns with a financial advisor. At Watts Gwilliam, we ask questions like:

  • Are you more concerned about losing money or losing purchasing power?
  • How worried do you think you would be in a severe market decline?
  • How much money are you willing to lose in the stock market?

 

It’s never too soon to start planning for your future. Contact Watts Gwilliam and get the conversation started.

 

What Is Risk Capacity?

Risk capacity is the maximum level of risk you need to take on to reach your goals. Unlike risk tolerance, it’s not rooted in emotions. It’s purely mathematical.

How to Determine Your Risk Capacity

Calculating your risk capacity involves evaluating your financial goals to see how aggressive your investment strategy needs to be to reach those goals. Here are some common factors that determine your risk capacity:

  • Your savings rate. How much of your income do you save each year? Your risk capacity will be lower if you save each month.
  • Your time horizon. When will you need your money? 30 years? Five years? The longer your time horizon, the riskier most people can be with their investments because there is more time to recover.
  • Your financial goals. How much money do you need to reach your financial goals? The loftier the goal, the more risk you may need to take on to make it happen.

Many people think your time horizon, age and income are all indicators of your risk tolerance. But it’s actually quite the opposite. These are all indicators of how much risk you can take on to meet your financial goals.

Risk Tolerance Vs. Risk Capacity

Just to reiterate: Your emotions determine your risk tolerance, while mathematics determines your risk capacity. These two concepts go hand-in-hand. But in financial planning, risk capacity is often the leading factor when determining your investment portfolio.

Let’s look at two examples:

Meet Sallie and Bob. They’re both 40 years old, they both plan to retire in 25 years, and they both have a high risk tolerance. Market volatility doesn’t scare them because they know they have decades to watch their nest egg rebound. But their risk capacities are quite different.

Sallie has a fully-funded emergency fund and no debt. She paid off her mortgage last year and doesn’t have any dependents. Based on her financial situation, she has a high capacity for risk. She can take on a more aggressive portfolio without jeopardizing her long-term plans.

Bob, on the other hand, is in a completely different situation. He’s married with two kids. He’s still paying off his mortgage and just used the last of his emergency fund to send his kids to private school. He has some retirement savings, but not much. Based on his financial obligations, he has a low risk capacity – even though he has a high risk tolerance.

What Are Unnecessary Risks?

Some risks are necessary and others, well, aren’t. Driving to work each morning, for example, is a necessary risk you have to take if you want to keep a roof over your head and food on the table. But driving 30 miles over the speed limit to get there isn’t called for.

Investing works the same way. There are some risks you can’t avoid and others you can – and should!

4 Ways to Avoid Unnecessary Risk

Follow these tips to avoid unnecessary risk in your portfolio.

  1. Don’t try to time the market. One of the things people are most afraid of losing in life is money. But here’s the ironic part: When we’re afraid of losing money, we tend to make emotional decisions that lead to us losing even more money. We pull out of investments when they’re on the decline. We try to time the market based on the latest stock trends. And through this process, we add unnecessary risk to our portfolios. Working with a financial advisor and having an unbiased, rational advocate on your team can make a big difference.
  2. Review your asset allocation and rebalance if needed. Over time, your asset allocation gets out of balance as certain securities perform better than others. Review your asset allocation at least once a year to see if you need to rebalance your portfolio – and remove unnecessary risk in the process.
  3. Diversify your portfolio. We’ve all heard the saying, “Don’t put all your eggs in one basket.” This couldn’t be more true for your portfolio. The key to minimizing unnecessary risk is to diversify your money as much as possible. Invest across different industries (i.e. technology, energy and healthcare) and across different securities (bonds, stocks and ETFs). When you spread your wealth out, you aren’t hit as hard if one security loses 50 percent of its value. Your other investments can help pick up the slack.
  4. Have your financial advisor run simulations. It’s extremely helpful to stress-test your portfolio. Your financial advisor should test different scenarios to see how your portfolio reacts to various market conditions, so you can make informed choices about your risk tolerance and risk capacity. Are you really better fitted for low risk portfolio allocation or should you be investing more aggressively?

The Bottom Line

Risk tolerance and risk capacity can be complicated, which is why working with a financial advisor can be a huge benefit. Should you have low risk portfolio allocation or high risk can be a very emotional decision when made on your own. Discuss your situation, your goals and your concerns with a financial advisor who can help you calculate how much money you need to reach your goals and develop an investment plan that gets you there.

If you’d like help determining your risk tolerance, your risk capacity and the steps you need to take to build a portfolio that lasts through the good times and the bad, contact Watts Gwilliam. We are a fee-only, fiduciary financial advisory firm headquartered in Gilbert, Arizona and serving investors nationwide. Our firm was established to provide a conflict-free environment as well as innovative investment and financial planning strategies to help you build wealth, generate income and secure your future.

 

David Watts
Author:

David Watts

Dave is one of the firm’s founders. He helps business owners, professional athletes, and other high-net worth clients develop and implement financial plans and strategies. He also specializes in helping those with single-stock positions to diversify and manage their financial lives. Other areas of specialty are wealth transfer plans for concentrated stockholders and business owners; tax minimization strategies for those with employee stock options; cash flow management; and risk management planning.