Getting to know your risk tolerance status
Not knowing your true risk tolerance can be hazardous to your wealth. Knowing your risk tolerance helps to shape your portfolio of products and the proportion of your investments placed in “risky assets”, i.e. equity. This article looks at the factors that affect your risk tolerance and the importance of determining an appropriate risk level.
Time horizon and financial obligations
Most articles seeking to provide financial advice focus on saving for retirement and ensuring that your nest egg grows faster than inflation to last long enough to sustain you in your old age. Although this is a serious issue, before you reach retirement you would ideally also like to live a full life. To do this you need to meet different financial goals along the way. These could include an overseas holiday, building your dream house or paying for school fees. And this is on top of your usual living expenses and debt re-payments. It is important to realistically estimate how much you’ll be able to save for medium- and long-term goals and how much you will need to cover sudden expenses.
It’s useful to look at your money in terms of investment time horizons. This can help you determine the amount of risk you can expose your money to. As a general rule the longer your time horizon the greater your risk tolerance should be. It is also important to note that premature withdrawal of funds from your savings can jeopardise the chances of you reaching your financial goals.
As an example, had you invested all your savings in the All Share Index in 2008 your risk tolerance would certainly have been put to the test. You would have really suffered if you needed to access your savings in December 2008 and been relieved had you stuck it out until the first half of 2011. Only investors with a high risk tolerance would look to be fully invested in equities. By definition investors with a high risk tolerance should look to invest in equities for longer periods. An emotional investor may have switched much of their equity exposure to the money market in 2008. In hindsight this would have been the worst thing to do at that time.
It is also important not to focus on short term returns, but on the diminishing volatility of returns in the longer term. In general, volatility tends to be much higher in the short term and can often distract investors from their long term objectives. In August 2011 we experienced a period that saw the US stock markets drop suddenly after rating agency S&P downgraded the credit rating of US treasuries. The following days saw markets rebound strongly as investors looked to capitalise on cheaper share prices and then plunge as fear re-entered the market. What changed between the days you may be wondering? Well, not much, but that just illustrates the power of investor sentiment and how irrational behaviour can influence your investments.
Ability to take on risk
Your current net wealth impacts not only the amount you are able to invest but also the amount of risk you can reasonably take when investing. The more money you have the more you can invest and afford to lose. You should remember that including too little risk in your portfolio puts it at risk of growing slower than the inflation rate.
Emotional tolerance to market fluctuations
Determining an emotional tolerance to losses is probably the most difficult part of the risk assessment exercise. Your emotional tolerance is normally determined in the financial planning process via a questionnaire that assesses the amount of losses you would be willing to accept on your investments.
The willingness and ability to take on risk should then be compared to determine whether there is a match. An example of a match would be where there is a high willingness and high ability to take on risk. When a mismatch occurs between these two, additional investment education will be needed to explain the risks thereof.
It is vital that you are actively involved in the emotional part of your risk assessment as you are the best judge of your own emotions. If you really are averse to market volatility it is important that this comes out in your risk assessment. It is therefore imperative that you remain as truthful and objective as possible in order to produce an accurate assessment.
All material subject to our Legal Disclaimers.