What is Risk Tolerance?
In a nutshell, risk tolerance is a term used to describe how an investor would feel under certain circumstances if their investment portfolio lost money.
The interesting thing about one’s tolerance for risk is, it is closely related to how an investment is performing at a given moment.
For example, Sammy buys 100 shares of ABC company at $50 a share. She sees the price climb to $100 a share in the first year. Based on these facts, we can’t really know what Sammy is feeling. However, if instead of the stock going to $100 a share, it went to $25 a share, we can probably all agree that she would be experiencing a different feeling.
Now, in theory, when one is younger, they should have a higher tolerance for risk if they have a long-term time horizon. Why? Well, they have more years to recover from a loss than someone who is just entering retirement.
Here’s where it can get interesting. Just because someone is young (or older) doesn’t predetermine how they should invest.
We have some younger clients that are pretty risk adverse and some older that are comfortable taking on more risk with their investments.
But wait, if one has less time to invest or more time to invest, shouldn’t that be the determining factor on how much one puts into stocks, vs. bonds, vs other assets?
Well, if you log on to your companies 401k site for example, you may see a screen that says you need to invest more or less aggressively. How do they know this? They are basing this on your age.
Here at FPS, we have found that even though one’s age can certainly be a factor, it isn’t the only indicator. Instead, we do a few things.
- Have a detailed conversation around your lifetime goals
- Determine what those goals will cost and factor in some inflation. That $5.00 loaf of bread today is going to most likely cost a whole lot more down the road
- Utilize some tools to help determine how you would feel if your investments lost value (even temporarily). We utilize some pretty sophisticated software to model one’s portfolio to see how it might do during certain historical events such as the 2008 downturn.
- We factor in other sources of income in retirement outside of your investments
- Everyone’s situation can be different. Don’t rely on what your neighbor is doing (or not doing)
Some other things to consider:
- The more investment risk one takes on, the greater chance of loss (even if temporary)
- If one invests in a less aggressive portfolio, their returns will not match the overall stock market
- Determining if the rate of return of your portfolio is sufficient to help meet your lifetime goals and if not, what steps you could use to help get you closer. (Investing more aggressively isn’t the only option)
As always, when making big financial decisions, it is always best to speak with and take the advice of a Certified Financial Planner® practitioner. Any questions, we are here to help you figure it all out.
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All the best.
Rick Fingerman, CFP®, CDFA™, CCFS®
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.