Greetings! I trust that this will find you well and enjoying life!
How’s your ability to withstand short-term losses? This is the question at the core of any discussion of risk tolerance. Some people are able to ride through turbulence in the financial markets with a shrug while others suffer headaches.
What life factors can shape your risk tolerance? Two come quickly to mind. The first factor is your age. The second is your time horizon.
As you age, you have fewer years to recoup market losses. So gradually reducing the amount of risk in your portfolio over time has merit. Wall Street firms have even created investments around this premise known as target date funds which are commonly featured in employer-sponsored retirement plans.
Your timeline to retirement can also influence your risk tolerance. If you are sure that you will start tapping into your retirement savings in 2021, your appetite for risk may pale compared to someone whose retirement may start at some vague point in the 2030s. Broadly speaking, your time horizon for any financial goal affects your risk tolerance in investing toward it.
What market factors can shape your risk tolerance? Two stand out. The most obvious one is market risk. One common measure of market risk is standard deviation, which tracks the variance of an investment’s return from its mean return during a stated period. Adding and subtracting the standard deviation to a mean return shows the range of returns that may be anticipated 67% of the time. If an investment has a high standard deviation, it means that its returns have varied from the mean to a greater extent than one with a low standard deviation. (You could argue that history means nothing with regard to an investment’s future performance and that argument is legitimate – but lacking clairvoyance, we study history.) Across 1926-2012, the S&P 500 had a standard deviation of 19.1%
Another method to weigh market risk is beta. Beta weighs volatility versus the S&P 500, NASDAQ or other broad benchmark. The benchmark is given a value of 1 and an investment with a beta above 1 would show greater volatility than the benchmark. A 1.1 beta indicates an investment that in theory should move 10% more than the benchmark does. The problem with beta is that some investments have low correlation to the benchmark used.
The impact of market risk can be magnified when a portfolio lacks diversification. Having more eggs in more baskets promotes more insulation against market shocks.
Secondly, you have inflation risk. This is the risk of your purchasing power lessening over time. When you invest in such a way that you can’t keep up with inflation, you lose ground economically. Suppose yearly inflation increases to 3% soon. That means that a year from now, you will need $103 to buy what you bought for $100 a year earlier. In ten years, you will actually need $134.39 rather than $130 to buy what you bought a decade back because of compound inflation. Its effect is just like compound interest.
Look at retirees with conservative portfolios featuring a plethora of fixed-income investments. In a world where stocks are returning 10% a year or better, their returns have been a fraction of that. In addition to the opportunity cost they are currently paying, they risk struggling economically if the pace of inflation quickly accelerates.
What kinds of risks do you feel comfortable assuming? This is the big-picture question, the question for today and tomorrow. A discussion with a financial professional may help you confidently determine your answer.
If you have any questions, comments or feel that I can be of service in any way with your retirement planning, don’t hesitate to call. And I want to add that we appreciate your referring us to your friends and family.