By Mark Colgan, CFP®
You’ve probably heard some variation of this question many times: “On a scale of 1 to 10, how much risk are you comfortable taking with your investments?” The problem is, that question couldn’t be more obscure. Supposedly, based on your answer (which is likely a shot in the dark), the question-asker can figure out how much you can handle investing your hard-earned money in equity markets.
Don’t get me wrong—this information is certainly important. But on its own, it’s not enough. It’s akin to telling a tailor your height. If you’re hoping for a perfect fit, they also need to know your weight, your body type, the style you prefer, your budget, and a whole slew of other factors.
To make smart money decisions, you need to know your “risk budget,” a number that goes beyond a 1-10 scale and considers both an investor’s risk tolerance and risk capacity. Let’s dive a bit deeper into how this works.
Personal risk tolerance is the amount of risk that an investor is comfortable taking or the degree of uncertainty that an investor can handle. Risk tolerance often varies with age, income, and financial goals. It can be determined by many methods, including questionnaires designed to reveal the level at which an investor can invest but still be able to sleep at night. Knowing risk tolerance is part of the process of determining how to allocate your portfolio between stocks and bonds. For example, let’s say you determine that based on a scale of 1 to 10, you feel your risk tolerance is a 7.
Now, with your risk tolerance in mind, ask your financial planner if you can afford to experience such risks. Someone could score extremely high on a risk-tolerance questionnaire, which in a vacuum would suggest that they could handle a more aggressive investment portfolio.
While important, risk tolerance says nothing about whether an investor can afford to realize such risks. Risk capacity measures how much risk your financial plan can or cannot afford to take. For instance, the longer you invest in the market, the more time you have to ride out potential short-term volatility and benefit from compounding returns. So if your investment objective is 15 years from now, your financial planning strategy can likely accommodate a high capacity of risk. However, if you are saving money for a down payment on a house in six months, the limited time horizon will greatly reduce your risk capacity. The short time frame may dictate a risk capacity substantially less than your personal risk tolerance. In summary, risk capacity, unlike tolerance, is the amount of risk that the investor “must” or “must not” take to reach their financial goals.
The Invisible Yet Significant Influence of Perception
Calculating your risk tolerance and capacity isn’t always straightforward because logic is sometimes overcome by emotion. Psychology points out that humans are very vulnerable to “recency bias,” a cognitive bias that favors recent events over historic ones. For example, it’s the reason last week’s big stock market decline weighs on your mind and gives you the feeling that things are not going to get better. While common and understandable, heightened emotions can cause you to temporarily understate or overstate your risk tolerance.
A great way to illustrate the differences between one’s true risk tolerance and risk tolerance temporarily influenced by risk perception is with a driving analogy. Imagine you’re behind the wheel of your car. You’re on a winding road you know fairly well. You recently downloaded a new album to your phone and you want to listen to it. So you grab your phone from the center console, and, in order to locate the music you want to hear, you look down for a moment. By the time you look up, you realize the road abruptly turned left, and you’re about to run off it toward a tree! Fortunately, you react in time and swerve back into your lane. In that moment (and likely for the next 10-plus minutes), you drive as carefully as possible, because your mind is overestimating the risk. At your core, you are still the same driver you were 10 minutes ago (your risk tolerance). If you were aggressive, you’re still aggressive. But in the face of almost running into a tree and being badly injured, the awareness you have of the danger (your risk perception) has skyrocketed. So your risk perception temporarily skews your risk tolerance.
It’s an all-too-common phenomenon. Psychologists describe the brain as having two possible states: hot and cold. The hot state is when we’re emotionally activated (e.g., angry, scared), and it hijacks us from thinking rationally and from most types of productive learning. Cold states are when we’re relaxed and best positioned for learning. As such, it’s vital to be mindful about your state of mind when making decisions about your risk tolerance.
After all, human beings are naturally averse to loss, and the pain of losing is more powerful than the potential to achieve gains. (1) This leads us to sabotage our portfolio by selling when scared, missing the vital recovery, and then reinvesting when you feel secure, which is often when the market is back up, securing your loss.
How do you make sure this doesn’t happen to your money? Take practical steps, like going on a news diet and turning off the radio stations, TV channels, and websites that cause panic. Then, once you are relaxed and thoughtful, reassess your feelings about risk tolerance. Also be aware of becoming too complacent. Going back to the car analogy: When we’re on a long, quiet stretch of highway that we drive frequently, we relax. In those moments, we underestimate the risk and may speed, read a text, or otherwise put ourselves in more danger than we normally would. In bull markets, we do the same thing. We see everyone else making more money, and we get greedy (or at least less fearful) and have an impulse to push our allocation toward more risky assets.
Now, with your risk tolerance in mind, ask your financial planner what level of risk your financial plan can afford or may require. Someone could have a high personal risk tolerance, which in a vacuum would suggest that they should consider a more aggressive investment portfolio—but their financial plan may not agree.
While important, risk tolerance says nothing about whether an investor can afford to realize such risks. Risk capacity measures how much risk your financial plan can or cannot afford to take. Three factors will dictate your risk capacity:
- Duration of time: The longer you invest in the market, the more time you have to ride out potential short-term volatility and benefit from compounding returns. So, if your financial plan is focused on a goal 15 years from now, your investment strategy can likely accommodate a high capacity of risk. However, if you are saving money for a down payment on a house in six months, the limited time horizon will greatly reduce your risk capacity. The short time frame may dictate a risk capacity substantially less than your personal risk tolerance.
- Required return: All financial plans assume a certain rate of return. If your investment results consistently fall below that assumption, your probability of success will be lower.
- Target volatility: Depending on several variables, you may need a portfolio with a higher or lower standard deviation to improve the probability of your plan’s success.
In summary, risk capacity, unlike tolerance, is centered around the needs of your financial plan, and it dictates the amount of risk that the investor “must” or “must not” take to reach their financial goals.
The Most Important Risk Is Yours
As you can see, there are a lot of factors to take into consideration to determine your personalized risk budget. So rather than completing a generic risk questionnaire, to properly calculate your personal budget, speak with your advisor about your tolerance for risk, adjusted for your cognitive bias and your plan’s risk capacity that considers your time horizon, required return, and target volatility.
It Seems Complicated…
Determining your personal risk tolerance involves knowing your personal preferences and balancing them with what you hope to achieve. Sometimes it’s helpful to have an objective third party help you lay it all out and walk you through different scenarios.
At Montage Wealth Management, our goal is to help you discover your personalized risk budget so you’re not only comfortable with your investment portfolio, but that it is also properly supporting your financial plan so you can feel confident about your future. We’d love to chat with you about calculating your personal risk budget. Reach out to us today to see the difference our proactive planning process can make in your life. Email email@example.com or call (585) 419-2270 to get started.