By Jamie Cox
Financial advisors love to talk about risk, but we’ve noticed that not everyone loves that terminology. Instead, clients like you tend to ask whether you’ll have enough money to reach your goals. You may worry about that question more than usual when certain things happen, like bad days in the stock market.
We may talk to you about risk when that happens, and I want to explain why that is. We’ll cover how we measure risk, how we take it into account when making your financial plan, and how it can help us evaluate whether you’re on the right track to meet your goals.
What is risk?
In the real world, risk means exposure to danger. It’s the same in investing, where risk involves exposure to a particular threat: losing money. While all investments carry this risk, some are viewed as riskier than others.
So why invest if it’s risky? Because there’s the potential for reward—your money could grow. Plus, not investing can also be risky. If you kept all your money in cash, inflation would likely lessen its value. In a sense, you’d be losing money.
In general, the greater the potential reward, the greater the risk involved. But some investors can tolerate riskier investments.
How risky are you?
When it comes to risk, there are two metrics we look at: risk appetite and risk tolerance. These can sometimes be combined, but I find it’s helpful to discuss them separately.
Let’s use a non-finance example: Adam wants to climb Mount Everest. He reads books about the climb and imagines his satisfaction at the peak. But as he starts to prepare, he realizes just how much training is involved. He also begins to understand some of the risks: losing a finger to frostbite, failing to summit, even dying. In the end, Adam decides to hike Machu Picchu instead.
In this case, Adam had a big appetite for risk, but his tolerance for it wasn’t as high. His tolerance might have been higher if he was already in great shape, if he had years to train, if he had a professional guide, or any number of things.
One of our jobs as financial advisors is to help figure out your risk appetite and then determine if you can tolerate that level of risk. We rely on more than just our instincts to determine these two things — we look at your circumstances, goals, timeframe, personality, and more. We also have questionnaires and software to help us quantify both your risk appetite and tolerance.
Measuring risk tolerance
Often, our circumstances affect how we think about risk. As Adam ages, his need to climb a mountain might be replaced by thoughts of a nice beach vacation.
Age can have that effect on investing, too. Younger investors often focus on growing their money, and they’re able to take on more risk to do that; they have more time to recover if something goes wrong. On the other hand, older investors may need to use their investments for income, so losing money is a much more significant concern.
Beyond age, goals, and circumstances can affect your tolerance as well. If your goal is to keep up with inflation (roughly 3 percent per year), it wouldn’t make sense to take on a lot of risk in search of much higher returns.
We build a financial plan and portfolio with these things in mind. Your appetite and tolerance for risk, or potential losses, is fundamental to how we plan.
One of the most significant risks in managing money is human nature. Often, we’re tempted to sell an investment that decreases in value. But selling on a downturn guarantees the loss instead of giving it time to bounce back. Knowing your risk tolerance helps us decide how to proceed in these situations based on historical data and potential outcomes rather than emotion. However, building a financial plan that accounts for your risk tolerance is only part of our job as advisors.
Consider two examples to better understand behavior risk — how our instincts can get in the way of sound investment decisions.
In 2009, home values were sinking and unstable; it seemed like a crazy time to buy a house. But if you purchased a property in 2009, it very likely grew in value over the following decade. To make that investment, however, you would have had to ignore your instincts as well as the daily headlines declaring a crisis in the property market.
Next, consider the recent bull market. When stocks are performing incredibly well, it can be easy to forget that they often go down, too. Corrections and downturns are normal. But, as I tell clients, if you haven’t seen a tiger in a while, it can be easy to forget that tigers exist. As advisors, however, we build your portfolios to account for tigers whether you’re thinking about them or not. We know that threats exist and prepare for them.
That’s why if you call our office worried about a downturn or your ability to reach your financial goals, we often talk about risk. If you have questions about your risk tolerance or how we’ve factored risk into your financial plan, we can discuss this in our next meeting.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.