Test your level of investment risk tolerance
When you are thinking about investing, do you consider risk? And, if you do, how do you assess your tolerance and capacity for losing money, especially if you are retired?
Risk tolerance is “the level of risk an investor is willing to take” — as good a definition as any. This one is cited in “How to Determine Your Risk Tolerance Level” (tinyurl.com/3rh8j55x), posted in the Intelligent Portfolios section of the website for Charles Schwab, a multinational financial services company.
Risk of loss is measured behaviorally against possible gains. People are usually biased to avoid losses (“loss aversion”), that is “the fear of loss can play a bigger role in decision-making than the anticipation of gains.”
Risk capacity is something very different. Capacity is all about how much you can afford to lose. For example, when moving from a working career into retirement, the transitional period is by far the most risky for anyone. Retiring at a market top is the worst time to begin a program of monthly withdrawals to pay for living expenses.
While a retirement timeline can last decades, be careful about advice that suggests you can take on more risk when your time horizon is long. The investment period of time is long, but the waiting period is not. That is, most people have to create a way to generate portfolio withdrawals over the decades of retirement. Risk has to be understood in those terms.
Contrast a young investor who is saving for retirement. The desired outcome is a large nest egg 30 or 40 years into the future. In that case, a long time frame until the savings and investment program matures can support a higher level of risk over that period of time — as long as the risk is reduced as one transitions into retirement. As I said, you don’t want to be hit with a downturn when you need your portfolio to shift into cash flow production after you leave your job.
In any event, trying to quantify risk tolerance is hardly easy for individuals to tackle on their own.
“Individual investors may also require an assessment of their intellectual and emotional tolerance for potential losses associated with risks; for these assessments, interviews or questionnaires can be used,” according to a 2010 position paper on investment policy statements (tinyurl.com/5yvu5bay) for CFA Institute, a global association of investment professionals.
If you want to try a selfassessment of your own, the University of Missouri (tinyurl.com/duaj25fc) offers one online that asks more than 20 questions and gives you a score that is linked to its interpretation of your risk tolerance.
Another option is Schwab’s Intelligent Portfolios (tinyurl.com/3a8x6wja). The robo-adviser asks 12 questions to get an assessment of not only the type of investments you want to make (including your goals and timeline), but what type of risk you are willing (or not willing) to take. You can do the assessment without opening an account with Schwab. (By the way, I have no connection with
Schwab.)
Whatever assessment a do-it-yourself investor may use, a client of a portfolio manager will likely follow a different path. For example, my personal experience running retirement portfolios calls for setting portfolio risk parameters in conjunction with the client instead of asking for a self-assessment. An acceptable risk level is built around desired longterm and short-term outcomes and the demands placed on the portfolio (cash flow requirements now and projected into the future), all in the context of financial market expectations. This method takes both risk capacity and risk tolerance into account.
How a financial firm determines risk tolerance for you is an important conversation to have before transitioning into retirement. My experience tells me that the most successful portfolios flow from an assessment of risk first, reward second.
On another matter, the deadline to apply for the 401(k) Champion Award, which shines a light on 401(k) participants who make good 401(k) decisions, has been extended to Oct. 28. To compete for the award, go to 401kchampion.com.
Julie Jason, JD, LLM, a personal money manager (Jackson, Grant of Stamford) and author, welcomes your questions/comments (readers@juliejason.com). Her awards include the 2020 Clarion Award, symbolizing excellence in clear, concise communications. Her latest book, a curated collection of Julie’s columns, is “Retire Securely: Insights on Money Management From an Award-Winning Financial Columnist.” To hear Julie speak, visit juliejason.com/events.