How do I gauge my risk appetite in my investment planning?

Answers

  • 4 out of 4 people found this answer helpful

    CFP®, ChFC, EA Redwood Shores, CA

    Most of us invest because we have to, not because we want to. While many enjoy watching the working of capital markets, to most investing is  a mean to an end, not an end itself. The selection of right risk level comes down to two questions: 

     • How much risk must I take? (i.e. what rate of return do i need to generate to get my goals, and what is the risk of investing that way?)

     • How much risk can I take? (personal risk tolerance is as individual as pain tolerance and some people are naturally more resistant than others. Selecting too high of a risk tolerance can result in making a wrong decision when markets get extreme) 

    Your actual risk level should lie comfortably in-between those two thresholds. 


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  • 2 out of 2 people found this answer helpful

    Decatur, GA

    There are two fundamental concepts for an investor to consider in gauging their risk “appetite” for their personal investment
    planning needs:

    1.  Risk tolerance: an investor must first consider the level of market risk that they
    are comfortable in assuming in their investments. Risk tolerance assessment is
    part of the fundamental due diligence an advisor will undertake in developing a
    financial plan with you, both in discussion and in formal paperwork.

    Please understand that risk tolerance
    assessments, while providing a theoretical framework to start your planning process, have their limits. First, it is an entirely abstract and subjective assessment, done in an office setting apart from the reality of the marketplace. Discussing risk and volatility in this environment is quite different from experiencing them and their real-world effect on your portfolios and financial standing.

    2.  Risk capacity: this is the risk that an investor “needs” to take in order to reach
    their financial goals, a more quantitatively based assessment of the investment plan that will be developed and implemented to do so. Another way to view this construct is in the determination of the dollar amount of loss that an investor can absorb and still meet their goals and/or maintain the standard of living
    they desire. 

    Some factors common in this determination may be, but are not limited to:

    * time horizon for the investment plan

    * liquidity needs

    * goals –short, intermediate, long-term

    * income - current, ability to replace
    loss, work life expectancy, retirement needs

    * wealth/net worth 

    This is just a starting point -there are many more factors and considerations that must be a part of the process before any investment
    plan is formulated, agreed upon and implemented. Consultation with a financial
    advisor that you are comfortable in working with should clarify these points.



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  • 1 out of 1 person found this answer helpful

    CFP®, MBA, MSFS Irvine, CA

    Most advisors use a risk tolerance questionnaire (RTQ) to gauge your appetite for risk. Be careful when you answer these questions because you may respond in a way that is not really reflective of you risk tolerance.

    For instance, suppose the question asks, "How would you feel if your portfolio went down 10%?" Worried, Terrified, Unconcerned. In a vacuum, your answer might be adequate to reflect your RT. But if the question was framed to include a time frame, you might answer differently.

    Suppose it said instead, "went down 10%, 1 time in 5 years?" Now what would you say? This means 4 of the 5 years were up and you were giving back some of your profit. What if it happens in the first year instead of the 5th year?

    Do you see what I mean? So a discussion is always warranted when answering these questions. Most investors will fall between portfolios. What I mean is their RT could be higher or lower than the score they get on the survey.

    So ALWAYS have a discussion with the advisor before you agree on which portfolio best reflects your risk tolerance.

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  • 3 out of 6 people found this answer helpful

    CFP® San Francisco, CA

    Your ‘risk appetite’ will be determined by a number of factors.

    You always want the risk you take with your investments to correspond with the purpose and timeframe for setting funds aside. ‘Retirement’ may be your purpose but everyone will have a different timeframe based on how long they have until retirement. Taking some risk can be OK when there is a long time before needing the funds – when you are closer to needing the money, less risk is advisable.

    If you will need the investment in 5 years or less, more liquid vehicles such as money market accounts and short-term certificates of deposit are most appropriate. When your timeframe is at least 5 years and preferably longer than that, allocating some money to the stock markets can work to your advantage. By taking the additional risk of the markets, you can get better returns relative to the safe and sound money markets and CDs. Bonds are debt instruments that pay interest to the holder. You can purchase them with maturities that correspond to your timeframe.

    An important consideration is your age. The younger you are, the more risk you can take as you have more time to ride through difficult market cycles. When you get older, you don’t have as much time to recover from bad markets so it is advisable to take less risk so the funds are there at retirement when you need them the most.

    A final consideration is you. Do you get stressed out when markets gyrate and your investments move up and down? If so, you may want to reduce risk in your portfolio and stick with safer money options, regardless of your age.

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  • 2 out of 4 people found this answer helpful

    San Francisco, CA

    There are two issues with risk.  The first is your financial goal for the asset: if you have a long-term goal a more volatile asset with a higher average return makes sense.  If you are looking to the short-term, you’ll want a more steady vehicle with a lower average return.  The second isse is your tolerance for volatility.  Can you remain steady when the asset is fluctuating (either on the upside or downside). 

    A recent study conducted by the University of California, Berkeley, and published in the November issue of the Journal of Marketing Research, took an unusual approach to exploring the emotional side of investing.  The researchers tested whether fear affects investing performance by showing one group of participants horror movies and the other documentaries.  Then, the volunteers participated in a mock stock market.  Those who watched horror tended to sell their stocks early, fearing losses, while those that watched the documentaries held their stocks longer. Due to its longer term approach, the documentary group had significantly better returns.  The study determined that the underlying cause of this phenomenon was social projection, whereby people tend to project their feelings onto others.  The study also found that fear lead to an early sell-off when a participant believed the value of the stock was peer generated, but not when they believed the value of the stock was computer generated.  This study offers insight on how we view the market and how that view reflects our stock performance.  If our investment view is short term, it is indeed peer driven, and subject to investor fear and greed.  If we take the long view, however, the market very accurately values the underlying strength of a company.

    I advocate a disciplined approach to selling holdings, seeking to enter investments with the goal of long-term ownership based on a company’s management, financials, and enduring business strategy.  Although, as Buffett said, we would ideally hold an investment forever, if the business fundamentals change, invalidating the original investment thesis, it’s time to sell.  Also, as we saw earlier this year, if there is a probable negative market event, it may also be time to sell.  Looking at the European debt mess, and the failure of the debt super-committee in the U.S., it may seem like it’s time to start selling.  I don’t, however, currently see these problems as leading to probable major negative events.  There are dangers, and something unlikely may happen.  Reacting to market unknowns, however, is the surest way to lower returns.  As the Cal study showed, when we look past fear at long term fundamentals, we gain a big advantage over those who do not.


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  • 2 out of 4 people found this answer helpful

    Marietta, GA

    This is a great question.  The answer is much tougher than filling out your typical "risk tolerance questionnaire".  Everybody loves risk when the market is up and is super conservative when the market is down, at least that is what they think.  It is up to us, the advisor, to really dig deep and find out what kind of risk is appropriate to you on the front end rather than after you deem yourself super conservative and then expect your portfolio to outperform the S&P 500.  All of the other things my colleagues mentioned are true, time horizon, withdrawal rates, etc... I personally think the most important factors are the psychological ones.  Did you grow up with money, what has your reaction been when you made an investment that lost, tell me more about that....How does losing money make you feel? 

    If you were given $5,000 and had 2 options.

    1.  flip a coin and either double (10k) it or lose and still keep the $5,000

    2. I would give you $7,500

    Which option would you take?

    Reverse question

    I give you $5,000 and you can either

    1. Take a sure loss of $2,500

    2. Flip a coin and keep your $5k or lose it all..

    Which option would you take?

    These may sound silly and hopefully a little fun but they can tell me more about your true risk tolerance than the standard...If you were to purchase an investment and it was to lose 1/2 it's value would you 1. Buy more..2. Sell it all 3. hold tight...4. Sell some. 

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  • 2 out of 4 people found this answer helpful

    CFP® Lafayette, CA

    At our firm, we take time to discover and understand a client’s goals, challenges, and current life situation so that we can help each client assess her or his own unique risk tolerance. A key component of this journey of discovery is determining what the overall goal of the investing process should be for you.

    Here are a few helpful questions you should consider: 

    •   What do your assets need to do for you? For example, are you looking to build a portfolio that will support you during retirement? Are you looking to create extra income for a down payment on a home? Determining the purpose for your investments is a key first step.

    •  What is your time frame for needing income from your investments? The shorter the time horizon, the less risk you should take. You may consider creating series of “time buckets” for your portfolio that coincide with your goals.

    •  What investment choices do you currently own in your portfolio? What is the strategy of each asset, what does it own, and do these holdings match your own beliefs and reflect what you want? It is important to always understand the details of the investments you own. 

    •  Here’s a good risk tolerance check test for you: Were you invested through the down market of 2000-2002 or 2007-2008? If so, were you nervous? Did you get out of the market at some point? Did you invest back in when the markets started to rise again or wait until there was already substantial improvement? Are you still on the sidelines? Sometimes, personal experience is the best gauge of your risk tolerance. 

    So, think about this: when you invest in anything, research how it performed in both up and down markets. In addition to reviewing 3, 5 or 10 year average annual performance, also look at performance in each individual year in order to gauge the volatility of that investment. You will also want to take into account technical analysis metrics and comparisons to other investments you are considering. And here’s one final thought: don’t forget to find out who is managing this asset now as well as when these past performance numbers posted. If there’s been a major shift in team members, research the new team separately from the investment. As you hear over and over again: past performance is not necessarily an indication of future performance. Shifts in management teams can be an important issue to take into account.  

    Your portfolio should be a direct reflection of who you are, your values, your risk profile, and where you are going in life. Develop a suitable portfolio using your risk tolerance as a keystone, and then stay on top of markets, your changing life and your changing philosophies, making key changes to your asset base as appropriate.

    Lynn Ballou is a CERTIFIED FINANCIAL PLANNER™ professional and co-owner of Ballou Plum Wealth Advisors, LLC, a Registered Investment Advisory (RIA) firm in Lafayette.  Lynn is also a Registered Principal and Branch Manager with LPL Financial (LPL).  The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendation for any individual.  Financial Planning offered through Ballou Plum Wealth Advisors, A Registered Investment Advisor and a separate entity.  Securities offered through LPL Financial, member FINRA/SIPC.


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  • 0 out of 0 people found this answer helpful

    CFP®, MSFS San Luis Obispo, CA

    There are a number of online tools you can use to gauge your risk appetite. One that I like is called RiskAlyze. It is free for you on the web (disclosure: we use the professional version with our clients).

    Be careful with these risk questionnaires, many do not separate out your "risk appetite" (or tolerance) from your "risk perspective." Many also ignore the difference between downside risk tolerance and upside risk tolerance.

    Also be VERY careful to avoid the assumption that taking on more risk means getting better long-run returns.

    RISK PERCEPTION - Generally, your risk appetite doesn't change. You are willing to take pretty much the same amount of loss (in percent terms) today as you were 10 years ago. What does change is your perception of how much risk exists in the market at any given time. When things are doing well (as they have been for the past several months or years), people begin to believe that the risk is somehow lower (even though the fundamental prices - and hence the real risk of investing - is higher than they were a few years ago).

    DOWNSIDE vs UPSIDE - Nobody complains when their investments are too volatile to the upside. Many people feel beat up when they are exposed to even modest losses. There is a difference ... and losses are harder to recover from than the equivalent gain. A 50% loss requires a 100% gain to break even. A 50% gain requires only a 33% loss to return to a zero sum result.

    MORE RISK does NOT = MORE GAIN - Two portfolios with the same target rate of return (let's say 6%) are NOT created equal. One could have significantly more downside risk exposure than the other. Looked at the other way, jumping from a moderate portfolio to an aggressive often will not increase the expected rate of return even though it has a much higher risk profile.

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    Advisors offer free consultations to determine if you're a good fit for one another. Providing more information in the consultation request will help advisors have a better sense of what you're looking for. The advisor will contact you via email and set up a time to meet. Depending on the advisor, and your preferences, this could be an in-person or online meeting. You are under no obligation to engage them after meeting with them.
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