At some point, you’ve probably been asked your risk tolerance regarding investments.
What is Risk Tolerance?
Your risk tolerance refers to your ability to withstand losses when your investments perform poorly. Risk tolerance is critical to constructing an appropriate portfolio, 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.
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
After identifying your risk tolerance, the next step 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.
|2022 Risk Tolerance vs. Portfolio Allocation|
|U.S. Stocks||International Stocks||U.S. Bonds||International Bonds||Alternatives||Cash||Unclassified|
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 65% in stock. (And this is down more than 9% from when we ran the data in 2018.)
- Cash is higher than what we would recommend for most people. This coincides with trends in the money supply, which is at all time highs since the pandemic. People may have legitimate needs for this cash, but for most individuals, we suggest holding 3-6 months worth of expenses as an emergency fund and deploying the rest into investments.
- With cash allocation high in 2022, investors are missing out on diversification (across international stocks, U.S. bonds, international bonds).
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 with our free guide 5 Steps to Prepare for Market Volatility.