As the economy is reopening and people return to normal activities, we all face this question; How safe do I need to be? With a surge of new COVID-19 cases in many states, practicing intelligent and informed safety measures becomes even more important.
Similarly for investors, after experiencing the dramatic stock market roller-coaster ride in the last five months, a question comes up: How much risk am I willing to take in my investments during this uncertain time?
Silver Oak has been using a two-dimension framework to help investors make informed and intelligent decisions on this, as shown below:
Your capacity to take risk is the amount of risk you should take so that 1) it will help you achieve your long-term financial goals. 2) you can tough through a catastrophic or prolonged market downturn without jeopardizing your financial security. It should consider your life stage, spending priorities and timeline, and the liquidity and inherent risks taken elsewhere in your financial life, such as your income sources, pension and social security, insurance, real estate, business etc. These factors are integrated in our financial planning process to determine the optimal risk/reward balance for investments.
Your willingness to tolerate risk is the amount of risk that you feel comfortable taking. We call it the “sleep at night” factor. It varies with your personal experiences and outlook of the markets, financial confidence and even marital status. For example, being married and making a good income increases risk tolerance while being single and losing earnings generally decreases risk tolerance.
Everybody’s risk tolerance is unique and changes over time and with new circumstances. When our brains see a trend, we believe it will continue for a long time. When markets go up, we tend to be optimistic and take more risks. When markets go down, we tend to be more risk-sensitive and flee to safety. The headlines cans exacerbate the situation.
As an investor, the most important job is to understand your risk tolerance well in order to stay disciplined during the ups and downs of the market.
While the concept of risk-tolerance seems easy, it can be complex.
What happens if an investor has inconsistency between his/her capacity to take risk and his/her willingness to tolerate risk? For example:
- A 30-years old high-earner puts all her retirement savings in cash because she hates to lose a dime?
- A 65-years old who is about to retire yet takes lots of investment risks in order to hit a home run?
- What happens when two spouses have different opinions of risk-taking and are not sure what to do?
A good advisor’s value is not just to understand and integrate your risk-tolerance dimensions at any given time, but also to help you build a solid investment strategy that’s fully aligned with it. It should not only achieve your long-term financial goals, but also allows you to feel comfortable with possible outcomes in the short term.
Having a conversation is the first step in making sure you are taking the appropriate amount of risk in your portfolio. Schedule a time with me to discuss the best way to approach your risk tolerance and investment strategy.