With my birthday on the horizon I’ve been thinking about what I’ve done throughout my life and what I’d still like to do. It’s interesting to look at those two lists and compare. Perhaps you’ve done this exercise. When reviewing these lists, I see a clear change in my personal risk tolerance over the years.
Risk assessment is something we all do every day of our lives. And regarding our investments, it’s definitely something we should be doing and reviewing at least annually. It is important to know that with each risk there is a certain return associated. Identifying early which risks one is willing to take, given the related return, can reduce a great deal of heartache in the future. There are numerous questionnaires available to help identify your risk profile. I use two such questionnaires which can be found at https://maximawealth.com/resources/resources/.
When assessing risk and identifying your risk tolerance there are few key questions to ask and answer.
1. Can you handle short-term losses?
The answer to this question is going to be different for everyone, and may even be different for you, depending on your individual goals. An investment policy statement (IPS) can help you maneuver through the ups and downs of the market, as well as address matters such as long-term goals and desired returns. I assist each of my clients in establishing an IPS after we define goals and objectives and clarify their current financial situation.
2. What fundamental factors can influence your risk tolerance?
It probably wouldn’t surprise you to learn that age is an important consideration; however, the second one might be a foreign concept – time horizon.
Risk and time
As we age, the amount of time we have to make up our losses is reduced. These losses could be in the way of money, time or even broken bones. This is why as I compared my two lists I wrote about earlier I recognize my desire to skydive when I was younger has now turned into specifying my desire to indoor skydive. So, it makes sense if one might gradually reduce the amount of risk in their investment portfolio over time just like one might adjust the different recreational activities as they age.
But what exactly is meant by time horizon. Basically, it is your timeline to the specific goal in which you are investing, such as retirement. This timeline can influence your risk tolerance. Identifying the desired time horizon is very important when it comes to choosing investments and your overall asset allocation for a particular portfolio.
With longer-term goals we can often afford to be more aggressive than with shorter-term goals. Take my skydive example above. If I were to skydive now and break my leg on the landing my recovery would likely be longer because of my age, whereas if it had happened when I was a young adult my bones and body could recover quickly.
“The torment of precautions often exceeds the dangers to be avoided.” – Napoleon Bonaparte
There is a relationship between risk and return. Risk is a necessary factor of return. Investors need to recognize this risk/return trade-off. Understanding this will lead one to recognize the importance for investors to manage risk even more than simply trying to reduce it. And this begins with understanding your risk tolerance and time horizon. Check in for my next blog discussing the risk/reward concept.