One of the most important factors to take into consideration when formulating an investing strategy is your level of risk tolerance. This will help determine whether you should choose more or less risky investments for your portfolio and retirement account.
If you have a low level of risk tolerance, you may be better off choosing investments that are more stable, less volatile and less likely to suffer large losses. Conversely, if you have a high level of risk tolerance, you may be more comfortable choosing investments that are more volatile and could lose significant value — but could also rise sharply.
How Advisors Generally Gauge Risk Tolerance
To help gauge their clients’ level of risk tolerance, most investment advisors ask their clients to complete a risk tolerance questionnaire. It includes questions designed to help both the investor and the advisor determine the client’s risk aversion so appropriate types of investments are selected.
Advisors are not required to ask clients to complete a risk tolerance questionnaire, but most of them do. Also, there is no standard format for a risk management questionnaire — advisors can ask whatever and however many questions they want. Nor is there a standard scale measuring risk tolerance: One advisor’s questionnaire might rate risk tolerance on a scale of 1 to 10 while another’s might rate risk on a scale of 1 to 100.
Primary Risk Tolerance Factors
Regardless of which questions are asked, there are two main factors that determine most investors’ level of risk tolerance:
- How many years will it be until you need to access the money invested?
The goal for many investors is to save money for retirement, so in this case, the question is: How many years until you plan to retire? The longer your investing time horizon, the more risky you can generally afford to be with your investments, because you will have more time to make up for short-term market drops.
- How prepared are you emotionally to withstand sharp drops in the market and the value of your portfolio?
This is the proverbial “How well do you sleep at night?” question. Even some people who have 20 to 30 years or longer until they plan to retire prefer to stay away from riskier investments because they simply aren’t emotionally prepared to deal with market volatility.
Another important factor that risk management questionnaires usually try to determine is whether or not you have access to other assets to help meet your long-term investing goals (like retirement). If you do, you might be able to take more risk with your retirement portfolio, even if you have a relatively short retirement time horizon.
Limitations of a Risk Tolerance Questionnaire
While risk tolerance questionnaires play an important role, it’s also important to recognize their limitations. The biggest drawback to risk tolerance questionnaires is that they are fairly generic. In other words, they aren’t customized to any particular individual’s situation. Also, different individuals can interpret questions differently, in which case their answers may not end up being reflective of their true risk tolerance.
These reasons are why it’s important to go beyond just completing a risk tolerance questionnaire and have a conversation with your investment advisor about how you feel about investment risk. Not only will this help you sleep well at night, but also it is the best way to make sure that you and your advisor are selecting the right types of investments to help you meet your financial goals.
For example, your advisor might ask how would you feel if the market dropped 10% in one week, or 20% in one month? Would you want to sell your investments in the face of such a steep drop — even if you are 20 or more years away from retirement? If so, you might be better off choosing less-risky investments.
Meeting Your Goals … And Sleeping Well at Night
Based on the results of your risk tolerance questionnaire and a conversation like this, your advisor can work with you to create the right asset allocation model for you. This will help ensure that you find the right balance that enables you to meet your goals and get a good night’s sleep.
At ACG, we go beyond the risk tolerance questionnaire by having dialogue with our clients to help ensure that we have an accurate picture of their true level of risk tolerance. If you have more questions about our approach to gauging risk tolerance, please give us a call.