Understanding and managing your financial risk tolerance is crucial for creating a personalized and effective financial plan. Your risk tolerance is a unique blend of your financial ability to handle fluctuations and your comfort level with volatility. By taking the time to assess your financial risk tolerance, you can make informed investment decisions and create a solid financial plan that supports your short-term and long-term goals.
Let’s explore the importance of understanding your financial risk tolerance, how to determine your risk tolerance level, and tips for building a tailored financial plan that considers both your personal preferences and financial needs.
Defining Financial Risk Tolerance
As we mentioned above, financial risk tolerance refers to someone’s ability to handle a certain level of risk vs someone’s personality style and willingness to deal with volatility. When building a financial plan, it’s important to differentiate between your “portfolio risk tolerance” and your “personality risk tolerance.”
In financial planning, these ideas refer to different aspects of an individual’s willingness and ability to take on risk, which is key to achieving your financial goals. Here’s a breakdown of the differences between the two:
Portfolio Risk Tolerance
Portfolio risk tolerance is an assessment of how much risk an individual is able to withstand with their investment portfolio. It considers factors such as
- Financial goals
- time horizon
- Income needs
It helps determine the appropriate asset allocation and investment strategies to align with the individual’s financial situation. A higher portfolio risk tolerance suggests an ability to accept greater fluctuations in investment returns in pursuit of potentially higher long-term gains.
Personality Risk Tolerance
Personality risk tolerance, on the other hand, refers to an individual’s natural or inherent inclination or disposition toward taking risks. It reflects a person’s psychological makeup, attitudes, beliefs, and comfort level with uncertainty and volatility. Personality risk tolerance can vary greatly among individuals, with some being more risk-averse and preferring stability and security, while others are more risk-tolerant, seeking higher potential returns even if it means accepting greater fluctuations or losses.
It’s important to focus on this tolerance profile, because as US News and World Report puts it, “Taking too little risk can lead to portfolio underperformance relative to what a retiree needs. Too much risk can lead to sharp downturns at just the wrong time.”
When we work with a client to build a personal financial plan, we consider a number of factors that may impact, or be impacted by their overall risk tolerance. These include
- Income sources
- Investing experience and knowledge
- Comfort with volatility
Balancing Risk Tolerance with Investment Goals and Financial Needs
Understanding risk tolerance is important because financial planning is a long-term process. Generally speaking, while financial plans can and should change over time as goals, needs, and market conditions change, you don’t want to make hasty decisions. If you’re able to create a financial plan and stay committed to it, you’re much better off than you would be if you started with one strategy and abandoned it down the road.
We sometimes say that financial planning is both a science and an art. The science aspect involves analyzing numbers and devising asset allocations based on data.
The art lies in recognizing that individuals do not function like mere spreadsheets or computers. While someone may have the capacity to tolerate higher levels of risk, it does not necessarily imply a desire to do so. The art lies in balancing the potential risks with the financial goals and doing so in a way that fits the individual.
When it comes to risk tolerances and goal-based investing, various factors come into play. Short-term goals, for instance, require a cautious approach as high volatility may not be desirable. Even if you identify as an aggressive investor, it’s important to avoid excessive risk-taking. On the other hand, intermediate or long-term goals may involve different considerations, as your perspectives and aspirations might evolve over time.
Constructing a well-rounded portfolio involves extensive research and consideration. It often includes diversification, which helps manage risk. For example, merely having two stocks in a portfolio may not provide significant diversification, whereas having a variety of investment vehicles that include those stocks may.
Common Mistakes in Assessing Risk Tolerance and Building a Financial Plan
It’s not uncommon for investors to have unrealistic expectations of growth and risk. Every investor would prefer high growth and low risk, but that’s seldom possible in reality.
It’s better to understand what normal volatility looks like and work to recognize historical returns, and then use this information to help guide your strategy. And here is where an experienced financial planner can help.
It’s also common for investors to misunderstand their own personal biases in terms of risk. Oftentimes we meet with folks that think their portfolio reflects a certain level of risk, only to find that it reflects another on closer inspection. It’s easy to believe that you’re on one end of the risk spectrum, but without a second opinion, your perception could be different from reality.
To better understand your risk tolerance in terms of personality and capability, various risk tolerance questionnaires are available. While these questionnaires can provide insight, they may not necessarily offer definitive guidance on what actions to take. An investor may think they are comfortable with a 20% decline when filling out a survey, for example, but may feel differently when actually experiencing that drop in real-time. Open communication and discussion with a financial planner are very helpful for understanding an individual’s true risk tolerance.
To learn more about building a Financial Plan for you and your family, contact us today!
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