What Is Risk Tolerance?

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Risk tolerance is a topic spoken about often in the media and financial ecosystem.  When you hear this discussed it usually gives you the impression that determining your risk tolerance is something easy to do.  In reality, determining one’s risk tolerance is more of an art than a science.

Tools and Timelines

There are many tools available to help you determine what your risk tolerance may be.  We have a Risk Survey on our site to help guide you in the right direction.  I use the words right direction intentionally because I do not believe that your score should be the only thing directing you on investing your monies.  I also believe, that what I call, the statement test is a good indicator of your risk tolerance.  This refers to how you feel when you receive a statement in a down market, are you comfortable or uncomfortable.  Depending on your score and how you feel during periods of volatility may direct you closer to what your true risk tolerance may be.

Part of your risk tolerance determination should also be your time horizon.  As an example, even though you may be comfortable being aggressive this may not be the best strategy with the funds you are investing to buy a house in the next five to seven years.  The monies set aside for this specific goal may be invested more conservatively, even though you have a higher risk tolerance because you know you are going to need them soon, and having them readily available at the time you do is important.

Tolerance Change and the Market

Many years ago during a period when the markets were increasing precipitously, I received a call from a client that wanted to know why his family’s portfolio was not increasing as quickly as the Dow Jones and/or S&P 500.  We discussed how his portfolio was more diversified than those indices and there were assets that he held, such as bonds, small-cap, mid-cap, and international stocks that were not performing as well at that time.  We explained how the diversification they currently had was hurting them from a performance standpoint, but it was in line with their risk tolerance which we determined together as being moderate.  The client understood and also knew that if they were more aggressive they would be benefitting from the current market environment.  They asked that we update the portfolio to reflect a more aggressive risk tolerance.  We had a lengthy discussion and decided to reallocate about 50% of the portfolio to see how they felt about the adjustment.  Of course, markets do not continue in one direction forever, and in the month following the allocation and tolerance change the markets began to be more volatile.

The client received their statement following the month of volatility and was shocked by the decline in their portfolio, roughly two percent in one month on the more aggressive assets, and the ones that we left as is were barely affected.  It allowed us to have the discussion again and showed the client in real-time how risk tolerance is something that just cannot be evaluated through the scoring of a quiz, watching markets go up and feeling comfortable, or simply ignoring the time horizon.

Understand, Monitor, Update

Risk tolerance is something that is multifaceted and needs to be reviewed on an ongoing basis and adjusted as time goes on.  Your tolerance can be affected by many things including, and this is not an exhaustive list, your tolerance for risk, time horizon, the economy, your financial position, level of employment, or simply the current markets.  The important thing for you is to understand your risk tolerance, continue to monitor it, and update it over time so your portfolio is reflective of it.

Risk tolerance could be complicated and your portfolio may or may not be reflective of yours.  We can review your portfolio and discuss what your risk tolerance is and/or should be based on your family’s situation.  You can feel free to schedule a 30 Minute Zoom Meeting for us to discuss what may be right for you.

This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice. Investing involves risk, including possible loss of principal. No strategy assures success or protects against loss. To determine what may be appropriate for you, consult your financial advisor.

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