What Is Risk Tolerance?
Most of the time spent in investment planning meetings revolve around what kind of returns one can expect from their investments. Often those return discussion are focused on one idea, such as “over time this moderate growth portfolio should deliver around 7% growth annually”.
Most of the time this kind of analysis does not consider what you must endure as an investor to get that average annual return.
What do we mean by that?
Investors generally understand that stock and bond prices fluctuate. However, what they often fail to realize is that in order to get that 7% historical annual return, the investor had to be fully invested in that moderate growth portfolio through all its ups and downs.
Yet when the markets fall, this fact is often swiftly forgotten as the investor runs for shelter.
In order to avoid this kind of panic, it would be far better to understand in advance how far your portfolio could decline in value, so that when it does happen, you are already mentally and psychologically prepared for the occasion.
Risk Tolerance is defined as that degree of variability in investment returns that an investor is willing to withstand (Investopedia). That sounds boorishly academic!
It might be better to compare risk to a speedometer. If you drive fast, you might make it to your destination quicker, but you also risk getting into a collision or an accident. The slower you drive the safer you will be, but it will take longer to get there.
So, wouldn’t it be ideal to understand your risk profile in terms of a simple speed limit? Some people love to drive 75 and get to there destination quickly, while other prefer to take their time driving 45 and get there safely.
In this way we could boil down your risk tolerance to a simple number from 1 to 100. This is important because ultimately what you want to know is if the portfolio you have is in line with your personal speed limit.
Fortunately, today there are great software programs advisors can use to measure risk tolerance in this fashion. Not only can you measure your tolerance for risk today, but we can also measure it over time as your situation changes.
If you would like to see a brief demonstration as to how this works, click below.