Health & Fitness
Does your investment portfolio mix match your risk tolerance?
By Terrance R. Gaertner
It seems that just about everyone has a pretty high risk tolerance when the markets are doing well. For the past number of years, since early in 2009, many people have adjusted their risk tolerance to accommodate the bull market.
It's no mystery that taking on more risk has the potential of having your portfolio earn higher returns. The definition of risk tolerance is the degree of variability in investment returns an individual is willing to withstand. When that variability is on the upside, most of us feel that we have a pretty high level of risk tolerance.
Unfortunately, investment variability has two sides, both up and down. It's the down part of the equation that gets people into trouble. Many investors seem to have a short memory.
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In 2008 when many investors felt that the sky was falling, many investors who previously thought they had a high risk tolerance flocked to safe haven investments, mainly cash because their individual risk tolerance wasn't what they thought it was.
Some of them are still there (sitting in cash) and have therefore missed out on the significant recovery that has occurred over the past several years. We should have learned something from all of this, but not all of us have.
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So how do you assess your risk tolerance? Some of the things that are likely to impact your risk tolerance include your age, investment experience, your net worth, the length of time between now and the time you need your investments for withdrawals and the amount of your current and anticipated cash flow or earned income. Then there is a purely psychological makeup of each individual that either allows them or does not allow them to comfortably accept downturns in their portfolio.
There is a risk/reward component to every investment. As an investor, it is your responsibility to understand the risk involved in each one of your investments. If you don't fully comprehend the risks involved in an investment, you probably should not be making that investment. A qualified financial advisor can often help you match up appropriate investments for your individual risk tolerance.
For many investors it will make sense to allocate some amount of their portfolio as designated "risk capital". The amount of risk capital that should be allocated will vary from individual to individual but in all cases, the individual should be able to survive comfortably even if they lose all of their risk capital.
There are a number of questionnaires that had been developed to help you assess your risk tolerance. One simple little exercise will help you to understand your own risk tolerance. Assume you are given 10 chips. Also assume you have 2 buckets in which to place those 10 chips. The first bucket we will call the "investment returns" bucket and the second bucket will be called the "preservation of capital" bucket. So how would you allocate your 10 chips?
But rather than look at any questionnaire to assess your risk tolerance, look back to 2008 and see what your reaction was. Did you stay in the market with most of your stock investments? Did you move everything to cash?
I think that your reaction to an actual severe downturn in the market is the most telling indicator as to what your risk tolerance is. Let's make sure we all learned from the experience of the 2008 downturn in the market to help us shape sensible portfolios going forward.
Terrance R. Gaertner, CPA and CFP, MS is president of Chicago Financial Advisors. He is a member of The Financial Planning Association. He has earned a Master of Science degree in Financial Services with a concentration in Retirement Planning. You can reach him at 847-825-9700 or 900 South Knight Avenue, Park Ride, IL 60068.