Assessing your risk tolerance is an essential component of planning. It drives how you should be invested based on your personality and how you might respond emotionally to market declines. There is a critical second component to the planning process as it relates to investing, an assessment of your risk “capacity.”
Determining your ability emotionally to accept risk drives how you should be invested. In 2008 if you were fully invested in the S&P 500 index your portfolio would have declined in value by 38%. We like to put that in dollar terms: a $1M portfolio would be worth $620,000 at the end of that year. Some people can accept that type of decline because they are confident of two things: markets do recover (albeit how long it might take is guesswork) and they have plenty of time before they need to touch their assets. In that sentence we have demonstrated both the person’s risk “tolerance” and their risk “capacity.” Unfortunately, many people in retirement cannot accept that large a decline and they may not have enough time for things to recover.
Assessing risk Tolerance:
Risk tolerance questionnaires are usually the method used to assess your risk tolerance. Until recently we used a type of questionnaire that asked questions of a more qualitative nature, for example: “How much could your investments drop before you felt uncomfortable?” The questionnaire we used was one that was created after years of academic research that relied on the responses from thousands of completed questionnaires to create a formula for translating responses into a risk “number.” We used that system for many years, recently though we adopted a different approach that assesses your risk tolerance using questions that explore how you might respond to the trade offs between gaining an uncertain percent on your portfolio with the possibility of a relatively significant loss vs a certain but small loss. Questions that show the types of trade offs that exist in investing real dollars might be better ways to capture your feelings about risk than qualitative questions that do not. Responses to the questions lead to a “risk number” that is on a scale of 0-100. For perspective the S&P 500 is assigned a risk number of 78. Risk numbers can be used to match your tolerance with a portfolio that has a similar risk profile, which is quite useful.
Assessing Risk Capacity:
Risk tolerance is half the equation, assessing your capacity for risk is just as important. Risk capacity is simply defined as how much money you can afford to lose without having to change your plans. Creating a financial roadmap helps you understand your risk capacity, knowing how much income you need from your portfolio each year to support your lifestyle will drive your risk capacity. For example, if you need to withdraw 5% from your investments annually that combined with a 20% decline in the market can turn a portfolio worth $1M into one worth $750,000 after just one year. If you have trouble adjusting to a cut in your spending and you still need to withdraw $50,000 from your investments suddenly your 5% withdrawal has become a 6.7% withdrawal, something that is not sustainable for a very long time. Your risk capacity can be increased by having some liquid assets available to act a “shock absorber” during market declines. A combination of 6-12 months reserves in a very liquid account like a safe money market account and having the equivalent of 3-5 years’ worth of your spending needs in fixed income can help improve your capacity to take risk on the remainder of your portfolio. We spend a lot of time here working to determine your risk capacity and helping with strategies to improve it.