Personal risk tolerance is the amount of risk you are comfortable taking or the degree of uncertainty you can handle. It may sound simple, but anticipating your future response is more difficult than you think.
The Challenge of Anticipating Future Financial Behavior
For example, if asked in a questionnaire if you like winter, you might say yes. When it’s late February, 20 below zero, and a blizzard is in the forecast – then you’ll probably say no and be wondering why you live in the Midwest.
Investing is like that. On a risk tolerance questionnaire, it’s easy to say you would invest more when the stock market is down 20%. In a real market crash, like we experienced in March, it’s hard to step up to the plate and buy stocks when nearly every expert is predicting Armageddon.
The Role of Risk Tolerance Questionnaires in Investment Strategy
Imagining your future behavior is not as easy as it seems. The risk tolerance questionnaire helps provide guidance about your risk capacity. However, if used alone, the risk tolerance questionnaire could be misleading. You may find yourself overinvested during a market crash and be tempted to sell your retirement funds at a discount. Or underinvested and losing purchasing power to inflation over the course of your retirement.
The outcome of the risk tolerance questionnaire should be paired with your risk capacity, or ability to take risk. There is no risk capacity scorecard. Ability to take risk is discovered through a deeper conversation about goals, other non-financial assets, insurance, longevity, health, and spending habits.
Case Studies – Balancing Risk Tolerance and Capacity
- High Risk Tolerance, Low Risk Capacity: This retiree has no pension, all their money in the 401k and an appetite for risk according to the questionnaire. Despite wanting to take a lot of risk, there is little room for error and the financial plan shows they do not have the ability to take risk.
- Low Risk Tolerance, High Risk Capacity: Let’s assume this retiree has millions saved for retirement and is very frugal with no risk of running out of money in retirement. The risk tolerance questionnaire score was low risk guiding them toward a very conservative portfolio. In this situation, they don’t have the willingness to take risk, but the capacity is there, demonstrating that the retiree could take more risk.
The Importance of Financial Advisory Services in Risk Tolerance
In each of these situations a deeper conversation with an advisor could help redirect and get the client invested in a portfolio that better matches the willingness and ability to take risk. If you are uncertain about your risk capacity and tolerance, give us a call at 262-522-4040 or schedule your complimentary, no-obligation review here.
Any opinions are those of Kowal Investment Group and not necessarily those of Raymond James. This material is being provided for informational purposes only and is not a complete description, nor is it a recommendation. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or a loss regardless of the strategy selected. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
