How can I determine the appropriate level of risk for my portfolio?
[david apted, vice president/ financial adviser, smith moore]
Risk tolerance is an investment term that refers to your ability to endure market volatility. All investments come with some level of risk, and if you’re planning to invest your money, it’s important to be aware of the level of risk you can endure. Your tolerance for risk affects your choice of investments and the overall makeup of your portfolio. That’s why I always do a risk tolerance worksheet with my clients. I also feel it’s crucial to have a thorough understanding of the client’s complete financial picture. Together, we review a chart that illustrates the relationship between risk and return for five hypothetical portfolios, based on a long-term (five- to 10-year) time horizon.
In addition, I ask a few subjective questions to help gauge a client’s tolerance for risk. Are they able to sleep at night knowing they’ve put a portion of their hard-earned dollars in a particular investment? Remember, it might be easy to tolerate a high-risk investment while it’s generating double-digit returns, but consider whether you’ll feel the same way if the market takes a downward turn, with your investment leading the way. It’s best to invest at the level of volatility you’re comfortable with. We then create an investor policy statement, putting the client’s strategy in writing and committing to a disciplined investment plan. It’s both a blueprint and a report card. Reviewing the document at least once a year allows the client and me to stay on track to reach his or her goals.
[andrew briggs , financial adviser portfolio analyst, plaza advisory group inc.]**
The goal of every investor should be to stay invested as long as possible. Some say the market is fully efficient, but it’s evident that at times investors act irrationally based on individual behavioral biases. Each portfolio’s risk threshold is determined by how much loss investors can sustain, financially and psychologically, without withdrawing their funds. An appropriate level of risk is one you can tolerate and stay invested with.
To determine appropriate risk levels, you must establish both your ability and willingness to take risk. First, define your ability based on your current net worth and future goals. After calculating the returns needed, assess your willingness for risk and fine-tune your portfolio accordingly. To determine your comfort level, keep in mind the behavioral aspects of finance. If you have a behavioral bias called ‘loss aversion’—suffering more psychological pain from a certain percentage of loss than gratification from an equal amount of gain—then you should construct your portfolio with a focus on downside volatility.
Risk often is perceived as the enemy, but it can be our ally during portfolio construction. Every portfolio consists of components that
either enhance return (stocks) or reduce risk (bonds and alternative asset classes). Since risk historically has been much more predictable than investment returns, investors may achieve the desired level of volatility in their portfolio by figuring out the optimal allocation to risk reducers.
**Securities offered through Royal Alliance Associates Inc., member FINRA/SIPC. Plaza Advisory Group Inc. is not affiliated with Royal Alliance Associates Inc.