Understanding Risk: Wants and Needs
People typically understand they shouldn’t be making lots of moves with their investments (which aligns with my strategically passive approach to investing), but they often forget that their portfolio from years ago likely isn’t aligned with their current risk preference or capacity of today. Many people don’t even know what their risk tolerance is, so you’re not alone if that’s the case.
Have you considered both how you want to- and should-be invested?
Let’s quickly breakdown two primary components used in establishing the level of risk you should be taking with your investments: risk tolerance and risk capacity.
Risk Tolerance
You’ve probably gone through a risk tolerance questionnaire to establish your risk preference at some point – this is the measure of how you want to be invested. Because investments move up and down (and what feels like corkscrews sometimes), I often refer to this step as determining which investment roller coaster you’re comfortable on before you’re going to get queasy and decide one of the kiddie-coasters is a better fit for you. If you can’t handle market volatility (such as that seen during the Coronavirus Pandemic), that means you have a preference for a more conservative portfolio, whereas someone with a strong gut who understands taking more risk may potentially lead to higher rewards would be more aggressive.
As you can probably tell already, this is primarily covering your emotions as an investor and how you’ll respond to losses. These questionnaires are typically required for industry compliance purposes, but many people do not recall going much further once they have their results to discuss how much risk they can actually take on, which would be assessing risk capacity.
If you want to apply this reading to your situation, take my risk tolerance questionnaire right now to establish your preference!
Risk Capacity
Your financial ability to take risks, which is your risk capacity, doesn’t always align with your risk preference, and we need to consider that amongst your portfolio’s needs. The capacity for risk may be significantly higher or lower than what you have a preference for, so we may need to meet in the middle of your tolerance and capacity as we select the appropriate allocations for your portfolio.
An aspect of risk capacity is the consideration of necessary risk. If you’re nearing retirement and are playing catch up, your risk need is going to be higher than someone in retirement who has an established financial plan giving them guidance and a strategic withdrawal program that is currently on track to meet their goals.
There are many factors that can drive your risk capacity up or down, which is why I believe understanding your entire picture through comprehensive planning is important.
Putting It All Together
When you combine your risk tolerance and capacity with your needs and goals, you end up with a decent perspective of how you should be invested.
Taking any single risk component on it’s own and building a portfolio around it is setting you up for an unnecessary run on your emotions. This could be a fear of missing out (colloquially known as FOMO) when you’re invested too conservatively in a bull market or panicking as equities fall in a bear market if you’re unnecessarily aggressive by holding too many equities for your needs.
Take care in building your portfolios and remember that being passive doesn’t mean you shouldn’t rebalance or reallocate your portfolio to match your risk preferences and needs.
If you need assistance with any aspect of “decoding” your current portfolio risk structure, please do not hesitate to reach out to me at (320) 362-6002 or schedule time on my calendar.