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Making Sense of Your Risk Tolerance

As a financial advisor, my general goal is to maximize return for a given amount of risk. But one of the questions I frequently get asked is, “How much risk should I be taking?”

Well, long time risk tolerance involves a simple calculation based on three factors:

  1. How old you are
  2. When you’re retiring
  3. How much money you need to retire

Traditional wisdom says that if you’ve got a long time until retirement, you can afford to take more risk. However, approaching retirement requires you to dial back the risk to avoid potentially losing your hard-earned savings.

The calculation of time-till-retirement is known as “ability to take risk.” In other words, how much risk can your portfolio handle given the time horizon and your financial needs and goals? This is a great start for establishing how much risk you should take.

However, many believe your actual risk tolerance should take two more factors into account:

  1. Willingness to take risk
  2. Behavioral biases

To clarify:

“Ability to take risk” encompasses how much risk your portfolio can handle.

“Willingness to take risk” is more about what you as an investor can handle.

If you have a long time until retirement, but your heart lurches every time you watch the news and see that the markets are down, you might have a high ability to take risk, but low willingness to take risk. Others might experience the opposite, where they can’t really afford to put their money in risky securities, but they feel a desire to “beat the market,” or invest in what’s hot.

Willingness to take risk tends to be driven by your personality, and is therefore more subjective. Ignoring willingness to take risk can be very dangerous, because it can cause you to make bad decisions during market volatility.

That’s why my job as an advisor is to help balance your ability and willingness to take risk with your portfolio. I’m intent on helping you reach your goals while ensuring you feel comfortable during rough periods.

The final consideration in risk tolerance involves understanding behavioral biases, or ways in which human thought processes influence our investing habits. For instance, all investors tend to have one or more exceedingly common biases:

  • Overconfidence

This is when an investor is too sure of their investment decisions and doesn’t consider downsides or alternative possibilities.

  • Loss Aversion

Investors who hate losses more than they like gains are loss averse, which can cause them to make decisions that help avoid loss, but are unproductive in building wealth or reaching goals.

  • Regret Aversion

Regret averse people don’t like to admit when they make bad investment decisions, even though it happens to everyone. This can prevent them from learning from mistakes.

  • Hindsight

Hindsight bias makes someone think they “knew it all along” when they made a decision— they always “knew” a bad stock would go down, or a good stock would outperform.

Above are just a handful of biases; there are many more that affect investor decision making. While biases impact everyone differently, no one is immune. As an advisor, it’s important for me to understand your particular behavioral biases when analyzing your risk tolerance, because it gives me clues about how best to work with you.

By understanding your ability and willingness to take risk, then navigating any behavioral pitfalls, I can best help you reach your goals and avoid making mistakes. That said, there are a couple caveats involved...

  1. Risk tolerance cannot be easily measured, so it’s best not to draw assumptions from what you think your tolerance is. Instead, my approach is to ask you some specific questions to reveal your risk tolerance and biases.
  2. Any investor’s risk tolerance may change over time, meaning it is important to reevaluate your risk tolerance on a consistent basis, especially as major life changes occur.

Most importantly, if you’re concerned about your risk tolerance or want to talk about how your portfolio aligns with your needs and goals, please reach out to us. We can take a look at where you are now and how we can get you where you want to be.