Risk Tolerance and Why It Matters For Your Portfolio’s Future
November 12, 2019 Author: Tess Downing, MBA, CFP®, Complete View Financial
As dad or mom (or both) likely told you years ago — and probably more than once — honesty is the best policy. We could spend time debating whether that’s always true when your significant other asks whether a particular piece of clothing makes a particular body part look fat, or whether they still have the athletic prowess they did in high school. When it comes to investing, however, and more specifically to risk tolerance, it definitely does hold true — at least, it does if you enjoy sleeping nights.
Risk tolerance has two aspects. The first is an assessment of how much risk you are psychologically willing to accept in your investments. The second is how much risk you should accept based on your financial position, including your time horizon. The two levels of tolerance can be very different — sometimes detrimentally so, in fact, as we will see shortly.
Risk is an Inherent Part of Investing
The whole point of providing a return to investors is to reward the risk they took in providing a business venture with some of their capital. Investors assess acceptable return in relation to risk based on the risk-free rate of return: the amount they could earn putting their money into an investment that has (practically speaking) zero risk instead of investing in someone’s biotech startup or WeWork or their brother-in-law’s llama farm. The amount of return produced by a risky investment in excess of the risk-free rate is the risk premium.
The standard benchmark for risk-free return is U.S. government bonds (of whatever maturity is appropriate). As of this writing, that is 2.40% for the 30-year bond, 1.92% for the 10-year bond, 1.58% for the one-year bond, and 1.57% for the one-month Treasury bill. We are, of course, in a very low interest rate environment from a historical perspective, although these rates have persisted for so long that some people may have come to view them as normal. Even going back just to the 2008 financial crisis, in early November the 30-year bond was yielding 4.25% and the 10-year bond, 3.83% while the one-month T-bill yielded a paltry 0.13%. (The differences in these numbers is important but the subject for another day’s discussion.)
Risk and return are therefore proportionate, with higher risk generating higher returns (albeit with an increased chance of generating zero or negative returns or even loss of invested capital). The financial marketplace in theory assesses the relative risk of all available investments and values them appropriately. (The phrase “in theory” is very important here. Over the long term, it generally holds true, but in the short term, markets can be distorted by psychological and other non-financial factors since they are made up of humans with all their foibles.) For bonds, the rating agencies play a role as well, although the market is still the dominant force.
Risks in Investing
There are actually two forms of risk in investing. The first is systemic risk, which cannot be eliminated because it represents factors that are beyond anyone’s control. Systemic risk includes macroeconomic factors (recessions, depressions, inflation, rising or falling interest rates, etc.), natural disasters (hurricanes, earthquakes, forest fires, volcanic eruptions, etc.), and geopolitical or human factors (wars, riots, terrorist attacks, political instability, government actions, incompetent political leaders, etc.). The only positive is that systemic risk affects all investments — hence the name.
The second is specific (or simply unsystematic) risk. As the name indicates, this is risk that is specific to a particular investment. Litigation, poor management, a fundamental change in the marketplace, emerging competition, or any of a host of other potential problems are all forms of specific risk. A timely example of specific risk is California’s Assembly Bill 5, which would require Uber, Lyft, DoorDash, and other “gig economy” companies to treat their workers as employees rather than contractors. Assuming the law stands up to litigation and ballot-box opposition, it will likely render the business models of those companies uneconomical in California, and if such reform spread to a large number of other states would probably destroy them.
Returning to the two forms of risk tolerance, let’s begin with psychological tolerance. This measures your comfort level with the risk of losing money. If you are uncomfortable with significant risk, you are risk-averse or simply conservative. The other end of the spectrum is risk-tolerant or aggressive. Risk tolerance is a continuum from very conservative to conservative to balanced or moderate to aggressive to very aggressive, and you need to determine where along that continuum you fall.
The second type of risk tolerance is more properly called risk capacity, because it is determined by how much money you can afford to lose on a given investment, which is a function of how much money you have (wealth) and your time horizon — how long you have until you need access to your invested funds. With a long time horizon, you have plenty of time to recover from even a significant investment loss. As your horizon shortens, you need to avoid large losses and therefore need to shift to more conservative investments.
To illustrate time horizon, consider the Nasdaq and the bursting of the dot-com bubble. In February 2000, the index reached a high of just under 4,697. In the crash that followed, it fell to 1,172 by September 2002 and did not match its previous high until November 2014. That’s a span of over 12 years just to break even. Imagine if you had been heavily invested in the Nasdaq in 2000 (as many people were) and planning to retire in 2001 or 2002.
Another important aspect of risk capacity is the tax implications of certain investments. Some allocation to a particular investment or investment class may be advisable for tax purposes even though it is otherwise above or below your risk tolerance.
A final consideration is liquidity. Certain investments are more easily and quickly accessed than others, so your potential requirement for cash and when you expect to need it will affect your allocation.
Challenges With Risk Tolerance
There are two main challenges associated with risk tolerance. The first is a disconnect between risk tolerance and risk capacity. Someone whose risk tolerance is much lower than their risk capacity runs the risk of underinvesting and therefore failing to reach investment goals or even outperform inflation. The more common problem is the person whose risk tolerance is greater than their risk capacity, leading them to take greater risks than they can actually afford.
The second challenge is when a married couple has very different levels of risk tolerance. Risk capacity can be objectively determined, but risk tolerance is very personal. There are a variety of ways to approach this issue. A demonstration of risk capacity might convince one partner to adjust their tolerance up or down as appropriate. Other possible resolutions include splitting the portfolio and investing each half according to that partner’s tolerance or splitting the difference between the two to arrive at a compromise tolerance level.
An honest, accurate assessment of both your risk tolerance and risk capacity is essential to successful investing and retirement planning. To speak to a financial planner about this need in your life, contact us today!