Investment Basics Part II – Risk Tolerance & Investment Horizon

In my last article, I outlined the basic asset types that are involved in investing. Just as important as knowing the types of assets that are available for you to invest in, is knowing how much risk you’re willing, able, and ultimately, should take. Of course, you want to keep your portfolio balanced, but there are different investment strategies that can come into play when you know what risks to take for your individual needs. So join me as I continue with part two of investment basics where I will explain risk tolerance.

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Podcast Time Index For “Investing 101: Overview Part 2 – Risk Tolerance”:

• 00:51 – Investing 101 Part 2
• 02:10 – Risk Tolerance
• 02:41 – Risk Tolerance Profile
• 10:18 – Risk Tolerance vs. Risk Capacity
• 14:23 – Investment Horizon
• 15:22 – Three Types of Investment Horizons
• 19:06 – Wrap Up

Risky Business

I’m sure you’ve heard of risk tolerance at some point, and if you’re like me when I first heard about it, you’re like, “What the heck does that mean?” It sounds like you’re tolerating the act of being reckless with your finances, but that isn’t what it is really about. One of the first things that I have clients do when it’s time for them to begin investing, is to take an investment risk tolerance assessment. I then evaluate the results and go over it with them and together, we come up with an investment strategy that falls in line with their personal financial goals as well as their level of investment risk tolerance. So, what exactly does risk tolerance mean?

Risk Tolerance – What Is It?

If you remember the stock market crash of 2009, the scene was brutal. There were images of Wall Street investors jumping out of windows, and the Dow Jones Industrial Average had fallen below 7,000. Here’s the thing, while many were panicking — and understandably so — the wise investors were buying up stock.

You see, both groups of people — the jumpers and the buyers — were reacting to their individual emotional response to levels of risk. Oversimplifying the thought, risk tolerance is basically just your emotional reaction to varying levels of risk. This is why, as financial advisors, we help our clients identify and understand their individual levels of tolerance by helping them create risk tolerance profiles. When I have a client take an assessment, I am doing so because I want to know that they aren’t going to hurt themselves in good times or in bad times.

Yes, I said in good times or in bad. Oftentimes, investors become even more aggressive during the good times, even to their own detriment. That’s why it’s so important to fully understand your own level of risk tolerance and how that can drive your emotional reflexes.

Investment Risk Tolerance Profiles

We are unique and complex individuals. Each and every one of us has our own personalities and comfort zones. So why would we think that this doesn’t extend into the way we handle our investments? Your tolerance profile tells a detailed story about you and the way that you view risk. You might be the type that stores cash in mayonnaise jars that you bury throughout your yard — very conservative — or maybe you want to hop on a plane to Vegas and put your life savings on black — very aggressive — because you truly believe that you have a fifty percent chance of winning.

Wherever you fall in that range, your risk tolerance profile is going to let me know, so I can help you to build your portfolio accordingly, and help to keep you safe from yourself in the process. Our team uses software that asks very pointed questions that clients then answer by selecting a number between 1 and 99. 1 represents the most conservative, while 99 represents the most aggressive.

How Do We Use This Information?

I can’t tell you how many times we have given the financial risk tolerance assessment to a client and then turn around to evaluate the level of risk in their portfolios only to find that they are investing at a risk level that is far below their tolerance levels. One client in particular — I was so angry about this — scored an 88 on their investment risk tolerance assessment, but their previous advisor had them investing at a level that aligned with a tolerance of 39.

In this client’s case, he had a long investment horizon and was willing to take a ton of risk. It turns out that the advisor ended up hurting my client’s financial life by causing him to miss out on the power of compound interest over the previous five years. All of this was because the advisor was more interested in selling him something than he was in the interests of his client.

RELATED READING: Investment Basics Part I – Asset Types

So, what we do with the information obtained from the tolerance assessment is we map out an investment portfolio — this includes, 401(k)s, real estate investments, bonds, equities, etc…, — that matches your individual goals and aligns with the level of financial risk appropriate for you. The purpose is to ensure that you are building your wealth as quickly and efficiently as you possibly can.

The opposite scenario can also be true. If a client scores a middle-of-the-road tolerance score but their investments are at an 80 or a 90 risk level, the overexposure to risk can be a killer if the market collapses. Back in 2008-2009, people with investments with risk scores in the 90’s lost about 50% – 70% of their value. Just think if this happened to your grandmother. How devastating would that be to her financial life? So this is important stuff, folks.

Risk Tolerance vs. Risk Capacity

At its core, your tolerance is determined by your emotional reaction to risk. Notably, risk capacity is the level of risk that you can actually afford to take. Your tolerance may say that you’re willing to roll the dice and invest at an 80 or 90, but your capacity might say that you can’t. If you’re older, you don’t have as long to recover from market fluctuations. Therefore, your risk capacity may not be as great as a younger investor.

On the other hand, one of my wealthiest clients is an older gentleman who has a risk tolerance score of about 70. His wife scored a 60, so between the two of them, they have a fairly high tolerance for risk. Because they also have more money than they could ever need, they also have a very high-risk capacity. If the market were to tank tomorrow, even with the most aggressive investments, they would still have far more money than they could ever spend.

So what I’ve had them do is earmark some of that money for their grandchildren. We now manage the investments for that money as though we were investing it for their grandchildren and great-grandchildren. The capacity and the tolerance don’t match their own but they are an outlier and this strategy works to accomplish their goals.

What is An Investment Horizon?

Not too long ago, I went skydiving. It was the first time I’d ever done anything like it before but I would absolutely do it again. While we were getting up to altitude, I was talking to my cousin — who happens to be a pilot — about how they land the plane. Rather than going from 14,000 feet to the runway in a matter of seconds, they circle the landing strip and gradually bring the plane down for a smooth landing. Makes sense, right?

Well, this principle is a lot like investment horizons. There are three basic types of investment horizons which we will get into, momentarily. But for now, let’s examine what an investment horizon is. Basically, investment horizons are a means of stating how long you have to wait for a return on your investment. I’ve discussed these, briefly, before but a young individual investor is typically going to have a much longer investment horizon than the small business owner that is nearing retirement. The primary reason for this is that the younger investor has a longer time for the market to rebound and recoup any losses he may encounter.

Three Types of Investment Horizons

1. The first type of investment horizon is what’s known as short-term, typically around three years. Let’s say you want to buy a rental property within the next three years. One way of accomplishing that goal is to set up a portfolio specifically for that goal. All of your investments — usually short, safe investments — would be targeted at providing a return that allows you to purchase that property within your three-year goal.
2. Next, is the medium-term or mid-level investment horizon. Medium-term horizons usually last from 3-10 years and are slightly more aggressive than the short-term investment horizon. Because you have a longer time to rebound, you can handle a little more risk, investing in stocks and bonds. In essence, you don’t have to cut your throttle quite as fast when landing the medium-term, going back to the airplane analogy.
3. Finally, we have long-term horizons. These are great for individuals who aren’t facing retirement anytime soon. In my own life, I am not dropping my cruising altitude to prepare for the runway quite yet. I have at least another twenty years to invest before I retire. This means that I can take some risks and not have to worry about being unable to outlast the market fluctuations.

I hope that this has cleared the air, so to speak, on risk tolerance and investment horizons. Now that you understand the difference between risk tolerance and risk capacity, reach out to our team. As I always say, life is hard. Life is complicated, but with the right knowledge, investing can at least be financially simple.

Be sure to get the most out of Investing by following the Personal Finance for the Business Owner series.

If you’re curious about what your risk tolerance level is and how it aligns with your portfolio, reach out to us. Our team would love to assess your situation and discuss it with you.