Every financial advisor you consult with will always have one thing in mind. What is my client’s risk tolerance? I am sure you have heard this term thrown around, without possessing any specific definition to it. Business Dictionary defines risk as, “The probability that an actual return on an investment will be lower than the expected return.” What does that mean really? It means that risk, as defined in the finance community, is the likelihood that you will not make the returns they promised you. Does that not sound counter-intuitive? On one hand they tell you that you can expect an 8% to 12% annual return on your investment, while on the other hand, they tell you that you may not actually be guaranteed anything they promised you. The market is out of their control after all, right? And if you lose money, it is not their fault. You knew what you signed up for.
In a sense, this is correct. There is a certain level of risk to everything you do in life. That also translates into money matters. You need to find out how much are you willing to lose to figure out how much you can make. Just like in matters of the heart. I am sure you know what you would sacrifice to see your children live healthy successful lives. Or the pleasures you are willing to forgo to help your parents get a house, or what you would do to make your significant other smile at you. We weigh the scale in all decisions we make to figure out if the risk is worth the potential reward.
The finance community looks at risk the same way we look at life. Therefore, you must figure out your risk tolerance when it comes to money before you buy a single stock. Stocks, as an asset class, are risky. Still, some stocks are riskier than others. If you are willing to venture down the speculation path, you may receive exponentially higher returns, but you will have to be willing to risk your investment capital to do so. If you are risk averse, you may only be willing to risk losing very little, therefore your returns will be what everyone else gets by default. You may also fall somewhere in the middle, which is fine too. Our goal is to figure out where you belong.
I like to take a few things into consideration when figuring out someone’s risk tolerance. Some of the items on my checklist are as follows:
Age: The closer you are to retirement, the less risk one should take, the younger you are, the more risk you can handle.
Financial stability: I do not recommend anyone with less than $10,000 after all expenses and retirement accounts are funded to invest in the stock market. Capital only helps with options, not when determining risk.
Personality: I know that not a lot of people take this into consideration, but every client I ever had in my hedge fund, I sat down with and got to know them a little. If I saw that the person is out-going and has a positive outlook, I may recommend a riskier strategy. If the person is more conservative, I generally tried to match their approach. Most important part here is to be able to listen to yourself and give an objective opinion of your personality. You can also ask a friend or family member to help evaluate you if you are having a hard time being objective.
Time frame: One of the most important aspects of risk profiling is to figure out your time. Do you plan to invest in stocks for a few years or for the rest of your life? It is okay if you change your mind later. Just beware that the time you must invest drastically changes the outcome.
Goals: It is good to have investment goals as well as life goals. I use goals as a way of tracking my investment journey. Since I plan to stay invested all my life, I set milestones to remind myself to be disciplined. Investment goals do not have to be about money. You can set goals correlated to specific personality traits. For example, you may set a goal that when the market dips 15% you will start accumulating positions in stocks you like. This sounds simple enough now. But when you see the market drop 15% in one day and people are panicking to sell everything, it takes courage and discipline to press the buy button. Sort of like how soldiers are trained to run toward the gun fire instead of away from it. You must fight all impulse to flee and stay put.
In conclusion, you may use some of the items I shared with you today to help you figure out your risk tolerance. There is no one size fits all method that I could find. After speaking to my colleagues about how they view risk, they agreed that everyone has a different way to measure risk. I choose to look at both sides and ask myself a few questions. How much risk am I willing to take for the potential rewards? Considering my state in life now, am I willing to risk more or less? This helps me to figure out my risk profile. A person who is the same age as me, income level, and economic status may have a completely different risk profile than mine. Therefore, I do not subscribe to the modern methods financial advisors use when determining risk tolerance and portfolio allocation. Find your own risk tolerance and look for the stocks that fit within those parameters. The market is big, there are stocks for all types of risk levels available. Next time we will match your risk level with some stocks.
