• Investing & Markets

Making Sense of Risk Tolerance

April 9, 2018 | Craig Birk, CFP®

At some point, you’ve probably been asked what your risk tolerance is regarding investments. Risk tolerance is critical to constructing an appropriate portfolio for each individual, but the industry in general does a poor job of using it. The first problem is a lack of standard definitions. Being “Aggressive” or “Moderate” or an “eight out of 10” can mean very different things to different people.

A second major problem associated with risk tolerance is inappropriate application of it. Your willingness to take risk is only part of the equation. Your objectives for taking risk are just as important as your stomach for it. The key is finding the right combination of need, desire, and ability to take risk.

Risk Tolerance Impacts Spending in Retirement

By the time most people reach retirement, they tend to be somewhat stuck in their ways regarding spending. Most retirees have a set level of spending that is very important to them to be able to maintain, but relatively few have a strong desire to significantly increase it. This isn’t always true, and there is absolutely nothing wrong with wanting to spend more money, but it simply isn’t a high priority for most people. This is usually not the case for younger people with rising incomes.

How much you want to spend has significant implications for using risk tolerance correctly. Specifically, risk tolerance must encompass a combination of both tolerance and objectives.

Getting Down to It: Identifying the Right Risk Level

In designing strategies for our client’s wealth, we’ve been careful to define risk levels using both risk tolerance and objectives, using standard language. Here are some high-level definitions we have developed:

Highest Safety – Market volatility makes me very uncomfortable. Safety is a much higher priority than growth for me, and I do not expect growth meaningfully above inflation.

Conservative – I am able to accept some volatility, but have difficulty stomaching meaningful fluctuations in account values. I expect long-term growth somewhat above inflation, but am/are willing to sacrifice up to half of my/our potential long term return in exchange for less volatility.

Moderate – I am comfortable with moderate volatility consistent with a diversified portfolio which includes a significant allocation to stocks. I prefer to sacrifice some long-term return in order to reduce risk.

Aggressive – My primary objective is to achieve growth, and I am comfortable with typical stock market volatility. Still, I am willing to trade a small amount of growth potential to reduce risk.

Highest Growth – I am willing to take a high degree of risk in pursuit of higher returns, and am very comfortable with the volatility of a 100% stock portfolio.

Designing a Portfolio to Reflect Your Risk

The step after identifying your risk tolerance is designing a portfolio that properly utilizes it – and that you will stick with. It turns out, a mismatch between stated risk tolerance and portfolio design is widespread. Take a look at Personal Capital user data from a large sample of those who have aggregated at least $50,000 of investable assets and indicated their risk tolerance. Here are average asset allocations for each risk group:

Risk Tolerance vs. Portfolio Allocation
US Stocks International Stocks US Bonds International Bonds Alternative Cash Unclassified
Highest Growth 57.09 16.94 3.78 0.88 4.33 6.96 10.02
Aggressive 52.40 16.51 6.64 1.52 4.21 7.28 11.43
Moderate 45.81 14.52 10.86 2.31 4.34 9.68 12.47
Conservative 37.17 11.57 16.16 3.09 4.38 13.79 13.84
Highest Safety 31.79 9.31 15.43 2.79 4.55 19.49 16.64

These numbers may provide some context about how you are investing relative to others who say they have the same risk tolerance. Please note these are not intended as recommendations of any kind – they are just interesting reference points.

The trends in the sample are about what one may expect, but it’s somewhat surprising to see the following:

  • The differences in average portfolios between risk levels are modest—even those who are “Highest Growth” actually only have about 74% in stock. (And this is down nearly 6% from when we ran the data in 2014.)
  • Cash is higher than what we would recommend for most people. There could be legitimate liquidity needs for this cash, but we are only looking at brokerage accounts here, and not including cash in bank accounts.
  • While the averages look reasonable, there is huge dispersion within each group. For example, of those who say they have aggressive risk tolerance, 20% have less than 40% invested in stocks. An aggressive risk tolerance doesn’t always mean you should have an aggressive asset allocation, but this kind of allocation likely signals some kind of disconnect.

Our Take

Higher returns come with higher risk, and being too conservative over time can be just as big of a mistake as taking too much risk. Risk tolerance is an important – but often misunderstood – aspect of investing. If you are going to lose sleep if market declines erase 30% of your liquid net worth, then you do not have an “aggressive” or “eight out of 10” risk tolerance. Then again, just because you can handle this kind of volatility doesn’t mean you necessarily should subject yourself to it.

Learn more about risk tolerance and how it fits into your overall financial strategy by reading our free Personal Capital Investor’s Guide to Volatile Markets.

Download Guide

Disclaimer: This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data’s currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

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