With this blog post we’d like to share some thoughts with our readers about investment risk tolerance.
Generally, we think about risk as a bad thing – something to be avoided. “I won’t drive faster and risk a speeding ticket”, and, “no, baby, that dress doesn’t make you look fat,” are examples of two conscious choices made to avoid unpleasant consequences.
The context for risk in this post is investment risk – I put money out there in some type of vehicle, and expect it to be returned to me, and then some. And then some can be interest, dividends, capital gains, and lottery winnings.
The risk return spectrum looks something like this:
- If I keep money under the mattress, what is my expected return? Zero. It is not invested.
- If I want safety, and put my money in the bank, what is my risk? Next to nothing. But the return is also small.
- I can make a little more money in bonds with some risk to my invested principal – largely interest rate risk.
- Continuing out the spectrum, I can invest in equities – common stock, either outright or in mutual funds. Now I expose myself to market risk. Over many years the S&P 500 Index has returned a little more than 9%. But to get that return, I have to invest for the long term, as the stock market is volatile.
- I can purchase options on those stocks, and potentially magnify the return even more – and substantially increase risk of loss.
- I can try to count cards in Las Vegas.
- I can buy lottery tickets based on the sure-fire formula I saw in a magazine at the Publix checkout.
How does an investor decide where on this scale to invest? There are lots of considerations.
First, somewhere on this chart the investor has to decide where investment stops and speculation begins, and then where speculation ends and entertainment begins. Still – the risk return relationship is simply one of degree, and each investor has to place himself somewhere on the line – money in the mattress all the way to the left, and putting it all on red to the right.
Next, time horizon. How soon do I need these funds? If I’m saving for a down payment on the home I hope to purchase in two years, the time horizon is short and minimal if any risk should be taken. A bank account works. Not much earned these days, but at least nothing will be lost.
If I am 40 and will work till 67, then maybe I’m willing to take on more investment risk, knowing that markets move up and down, but the long term trend is upward.
After that, the tortoise or the hare? How much variability can I stand on the way to my goal? In other words, if I have $1000 to invest, and I know that over time the investment will grow 10%, can I stand it if it drops to $900 at some point along the way? How about to $800 – or even lower?
Answering these questions is a crucial part of the work we do with our clients. There are lots of risk tolerance measures out there – questionnaires with embedded algorithms which, after I answer a few questions, tell me whether I’m moderate, moderately aggressive, or an aggressive investor. How useful those labels are for an individual investor is unclear.
To that end we have introduced Riskalyze into our practice. It is one of the more awesome pieces of new software we’ve encountered. It is intuitive, and easy to use.
The steps are these:
- The client completes the questionnaire. The result is a risk score (shown above).
- Analyze the client’s current portfolio. A second risk score is generated for the portfolio. The two risk numbers will invariably differ, and then the discussion happens – what do we adjust? Your perception of investment risk, or the securities in your portfolio?
- Project out the likelihood of reaching one’s retirement goals. Riskalyze will take the score of your current portfolio, your current age and projected age at retirement, rate of savings, and income required and calculate the percent chance of you reaching your goal.
Please visit us at http://cameron-downing.com to make an appointment.
Glenn J. Downing, CFP®
Jonathan G. Cameron, CFP®
Note: A little background: in our work, we rely, of course, upon our computers and the software that runs on them. We have programs to type letters and create spreadsheets. We have a client database manager. Our emails to you are stored in your client record. We have cloud document storage. We have a website and this blog. We have software that captures images of the website and blog daily for compliance purposes. We have software that encrypts emails for your security. We have software that lets you book an appointment with us online. Still another program assists us in mailings. All of this yields tremendous productivity, when it all works together. Which is the next challenge – meaning choosing software packages that talk to one another and integrate with one another. All of this is new, and what’s good today may well be surpassed tomorrow.