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Defining Risk Tolerance: What's Your Number?

By Jonathan Peyton
August 02, 2017
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For years investors have contemplated how much risk they should take within their portfolios, and whether it is enough to reach their intended goals.  Depending on the time frame allocated to reach the goal, the type of goal, and the funds needed to achieve the goal, the appropriate level of risk can vary widely.  Unfortunately, without an appropriate understanding of what it takes to achieve an investor’s goal(s), the desired level of risk can be misjudged and unnecessary risk may be taken.  It is our belief that there are specific elements that can affect the pursuit of achieving any goal.  This article attempts to explain these elements as it relates to goal planning.  However, since everyone’s situation is different we strongly suggest working with a financial professional when applying these concepts to your situation.

 

Relationship Between Risk and Return

To explain the relationship between risk and return we first need to break down the components.  According to Webster's dictionary, risk can be defined as the chance that an investment will lose value.  This means that there are varying degrees of risk for different types of investments.  For example, a U.S. Treasury bond will have a very different risk profile than purchasing a blue chip large cap stock in the S&P 500.  By appropriately determining how much they are willing to lose over a defined period of time, a person can select investments that align with their desired risk profile.

Coincidentally, return is directly linked to the risk level someone takes.  It would be fair to say that the more risk an investor takes, there is potential for more return over a defined period of time. According to the risk return trade off, invested money can potentially render higher profits only if the investor is willing to accept the possibility of losses.  Furthermore, since different types of investments can offer types of risk (i.e. default risk, interest rate risk, equity risk, political risk) it is important to make sure the desired return can be achieved within the specified period of time.  Otherwise, the risk level taken for a potential return may not be appropriate for the period of time left to reach the original goal.  This leads us to the all important question, how much risk should an investor take for a desired level of return?  

Many years ago a company came out with a marketing campaign that was designed to ask the average investor, What's your number?  The intention was to have the audience think about how much money they needed in order to retire comfortably.  While the ad was catchy and thought provoking, it only scratched the surface of an underlying fundamental question: what does someone need to do in order to achieve a goal?  After reflecting on the underlying principles of the campaign, I reconsidered my outlook on investing.  I began to think about what the required rate of return would be to give an investor the best possible chance of reaching their future goal.  This inflection point allowed me to tweak the concept of the marketing campaign from a desired number of assets to a required rate of return.  Doing this opened the door to a new thought process; if an investor can obtain their desired return and corresponding goal with a lower level of risk, then what advantage would there be to chasing market performance? Translation, if an investor’s personal rate of return is directly linked to their goals, then overall market performance should hold less weight when judging an investor’s long term success.  

It is important to note, in order to appropriately measure a person's personal risk and return profile, they need to start with an outline of their short, intermediate, and long term goals.  Then they need to layout the appropriate time frames for those goals and determine which resources (i.e. assets or cash flow) will be used to fund a particular goal.  Doing this may mean each goal bears a different desired rate of return.  The aggregate weighted return across all goals should be viewed as the “Personal Rate of Return” needed when measuring the impact of progress toward a financial plan.  In other words, the aggregate average required rate of return outlined in a financial plan acts as the investor’s personal rate of return.  It is then left up to the investor, or their advisor, to determine which accounts should be invested with potentially different risk levels that align with the investor’s stated individual goal, and overall financial plan.

 

Risk Tolerance Questionnaires

At the beginning of every investment meeting with a client an advisor attempts to discern the client’s comfort with market volatility.  How? The predominant way an advisor begins the dialogue about risk tolerance is with a risk tolerance questionnaire.  A risk tolerance questionnaire is designed to help identify an investor's risk profile by asking fairly ambiguous questions and ultimately creating a risk tolerance label such as Moderate Conservative Moderate, Moderate Aggressive, etc.  While a risk questionnaire is a starting point in the conversation, the questions often lack qualifiers thus leading to a risk assessment that may not be accurate or permanent. Too often I have seen a client state their risk profile is one label but when the market goes haywire they immediately want to change the risk profile.  This defeats the purpose of the questionnaire as the list of questions are intended to assess an investors comfort with volatility over a period of time and based on a measure of market volatility.  Furthermore, risk tolerance does not change overnight, barring a significant change in someone’s personal or financial life.  This is why working with a financial professional to understand the questions being asked on a questionnaire, the impact of the results, and how to apply the results to different investment goals can help manage the risk return tradeoff in different market scenarios.

 

Risk Return Trade off

Now that we have outlined two very important components when constructing an investment portfolio, and the concern for ambiguous interpretation of risk tolerance questionnaires, we need to turn our attention to the risk return trade off.  Risk and return do not share a linear relationship.  In fact the relationship between risk and return can be measured by the investments used within a portfolio.  As stated earlier, every investment bears some level of risk, and for the risk taken an expected return can be calculated.  Suffice it to say, without getting into complex formulas (i.e. CAPM, Beta, Sharpe, Sortino), that an investor can attempt to optimize their portfolio’s expected return by managing the different risks observed impacting their portfolio.  When done correctly, an investor or their advisor can construct a risk return trade off matrix.  Unfortunately this matrix is not static and should be assessed frequently as different risks can change based on external factors.  Therefore, to appropriately optimize the risk return trade off taken within a portfolio, a level of active management is required by either the individual investor, or by their advisor.  This is where the argument between active and passive investments has become a widely debated topic, which we will leave for another article.

 

Conclusion

Risk is a tricky topic and one that should be assessed frequently, and ideally with a trained professional.  More often that not, investors tend to let emotions impact their financial decisions which can lead to unfortunate outcomes.  An example of this relationship can be seen when equity market performance trends positively and investors think it won’t end. In this situation it is not uncommon for an invincibility mentality to take hold.  During this period a person is willing to continue to take risk, maybe unnecessary risk, with the expectation of reaping the benefits of positive momentum.  Unfortunately, without fully assessing their risk in the moment they become biased to their success, and rational thought tends to leave as emotions take over.  For this reason we encourage all investors to regularly review their goals, their progress towards reaching their goals, and their defined risk levels for each goal as they invest for the future.  Only after an investor performs these tasks can they understand the relationship between risk and return, assess the risk return trade off, and appropriately apply these principals to their own investment strategies.  

 

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Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.  Investing involves risk including loss of principal.  No strategy assures success or protects against loss.