When it boils down to it, all investors want the same thing, that being the highest possible return with the least possible risk. Therein lies the problem. Every investors’ understanding of and ability to bear risk is different. For this article, risk is defined as the possibility of loss attributed to market volatility.
Most investors have little problem articulating their risk tolerance upon engaging the services of a financial professional. When asked to complete a risk assessment, investors can quickly check the appropriate box - conservative, moderate or aggressive. They also have no problem selecting a number on a scale of 1-10 that most closely corresponds to their risk tolerance. They can even answer the question that asks “What would you do if the market dropped 20%?” (Sell all, sell some, sit tight or buy more). If only it was that easy. It’s one thing to reflect on your perception of your tolerance for risk but another thing altogether to experience it.
A diversified portfolio’s asset allocation (the unique blend of stocks, bonds and cash) will determine that portfolio’s risk/return characteristics. Selecting a long-term asset allocation based on a subjective perception of your short-term risk tolerance is a dangerous practice. Most investors do not have a clue as to their true risk tolerance. It is only when exposed to a specific risk that can you actually know how you would respond. Perception isn’t always reality.
Investors actually have two tolerances for risk, high and low. When someone takes a risk and is rewarded, they love risk. In fact, they can’t get enough risk and may even want to increase their risk exposure. Conversely, when they lose money, all of a sudden they hate risk. Since an investor’s perceived risk tolerance is often a result of their most recent experience it can also change with the wind. It is irrational to think that anyone would adopt an asset allocation policy based on a subjective perception of their risk tolerance. Yet this is what the majority of investors are unwittingly doing aided by many financial professionals. There has to be a better way and there is.
Since most rational investors would not knowingly accept more risk than is necessary to achieve a particular goal and since we know our perceptions of risk can change, why not adopt a different approach? Replace subjectivity with objectivity and find out how much risk is needed to achieve your goals - no more, no less. Acknowledge your “current” subjective feelings about risk but also consider your risk capacity which is a function of objective data such as your desired retirement age and expected longevity, current and future savings capabilities and other data. Then work with your advisor to create a financial plan that incorporates your goals, objectives and all available resources to fund those goals. Next, find that asset allocation that will offer you a reasonably high probability of success, yet (and this is the key point) without unnecessary risk. The answer is there if you know where to look.