I’ve written many times before about investment risk and its role in your financial plan.
And I’m amazed at what continues to persist as the predominant method of determining the level of investment risk you should expose your portfolio (and your lifestyle) to. It goes something like this:
You meet with an advisor or are sent a questionnaire with somewhere between 5 and 25 multiple choice questions on it. These multiple choice questions ask you things like:
If my investment portfolio begins to drop in value, I will
- sell all of it
- sell some of it
- hold and do nothing
- invest more into the portfolio
When making an investment, I plan to keep my money invested for
- 1-3 years
- 4-7 years
- 8-12 years
- 13+ years
Generally, I prefer investments that
- have a higher potential for return even if their value can fluctuate widely
- have a lower potential for return in exchange for less fluctuation in value
- have little potential for return and little fluctuation in value
What these questionnaires are designed to do, although they’ll never admit it, is ask you to determine your tolerance for risk. In other words, how much “pain and suffering” are you willing to experience with your investments in exchange for the promise of returns?
To put it another way, most advisors, armed with their risk tolerance questionnaires, are asking you to identify how much risk you can tolerate, and then they will proceed to recommend a portfolio that will expose you to your tolerable level of risk.
Some of these advisors might explain that they want to build a portfolio for you that will give you the maximum level of risk for your stated level of tolerable risk. But the reverse is also true, and their recommended portfolio will also have minimum amount of risk for a stated target investment return.
But should you invest your money and build your financial plan around risk tolerance and risk versus return relationships?
Absolutely not, if you ask me.
It’s About Your Need, Not Your Tolerance
Instead of solely looking at how much risk you can stomach and then proceeding to expose you to that exact level of risk, advisors should consider your need for risk.
For example, even if you can tolerate a higher level of risk, should you take that risk even if you don’t need to in in the context of your financial plan?
Or course not. That would be exposing your money and your lifestyle to unnecessary risk. Risk that could compromise your achievable lifestyle in the future.
As William Bernstein likes to say, “When you’ve won the game, why keep playing?”
So rather than focus on your risk tolerance which is derived from a set of multiple choice questions, I think the better approach is to focus on your need for risk.
Determining Your Need for Investment Risk
So how do you determine your personal need for risk? It all begins with your financial plan.
Only after exploring, quantifying and recording your values, goals, and priorities can we begin to build your financial plan. And once we have a plan together that we can stress test against potential future market outcomes, we can then begin the process of understanding how different levels of investment risk impact the confidence level in your plan.
Sure, in many cases, taking more risk over time will lead to potentially improved financial outcomes down the road. But are you willing and able to experience the volatility that is associated with higher risk and stick with your plan through thick and thin?
More importantly, do you need to take the additional risk for the hope of a better future, or can you achieve your goals with a lower level of risk?
Consider that risk is like currency that you can “spend” in exchange for future goals.
Let’s use an example to illustrate these ideas. Say you plan to retire at age 60 and spend $100,000 per year in retirement. We need to stress test this goal to decide whether or not you truly can make this happen.
We have 3 variables to look at when we stress test:
Time represents the timing of your goal.
Cashflow represents your savings and spending. Prior to retirement, you’re probably saving money through a company sponsored 401k or into a savings account at your bank. Once you retire, your savings will likely stop and then you’ll transition into spending mode. How much you’re saving or spending is captured in the idea of cashflow.
And finally, risk is determined primarily by how you allocate your investment portfolio among stocks, bonds and cash.
Now, let’s imagine that only weeks after your 56th birthday, your husband experiences some severe health issues that have you considering an earlier retirement so you can help care for him and spend more time with him before his health worsens.
Here are your choices:
- Retire sooner by spending less in retirement
- Retire sooner by taking more investment risk
- Retire sooner by spending less in retirement and taking more investment risk
- Assuming you’re currently saving money, you could also consider saving more to help support an earlier retirement.
After evaluating the choices above, you elect to take on more investment risk in your portfolio to help make an earlier retirement a reality.
But then, just months later, your husband makes a miraculous recovery and his previous health condition is a thing of the past.
While you may still want to consider retiring earlier, let’s assume you enjoy your work and your colleagues and revert back to your retire at age 60/spend $100,000 in retirement goal.
Here’s the Big Question in Determining Risks
From the example above, the big question becomes: do you keep your investment risk at the higher level based on the prior, early retirement assumption?
In raising your risk, you clearly demonstrated a “tolerance” for higher risk.
But now, if you plan to scrap the retire early scenario and go back to working until age 60, assuming nothing else has changed, you’re now taking risk that you don’t need to expose yourself to.
The only reason you’d leave your risk at the higher level would be if you wanted to spend MORE than $100,000 per year in retirement or you had other goals you wanted include in your plan.
One of these might be that you’d like to save less of your current income while you continue to work. Higher investment risk might make this possible.
Admittedly, this is a simple example. You will have many more variables and assumptions that will play a role in your personal financial plan. But this shows how risk is simply another financial planning variable.
It should be determined based on your need to take risk instead of basing it only on your personal pain threshold. But you can’t fully explore and determine your need in the absence of a comprehensive financial plan.
And for all of those financial advisors out there investing your money without the context of a financial plan, I’m not sure what they’re thinking.
I would encourage you to discuss this with your advisor and ask him or her how they’ve determined your need to take risk instead of relying on your tolerance alone.
And if you don’t have a financial advisor and would like to discuss this important topic, I’d be happy to have that conversation with you.
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