The “Risk Tolerance” Mistake That Could Lead You To Financial Disaster

I read a number of great personal finance blogs including the Oblivious Investor written by Michael Piper.  Recently, I found a guest post by him on the Bible Money Matters blog, called How To Determine Your Risk Tolerance.  In the article, he struggled with a very important question:

“How Does One Determine Their Risk Tolerance?” or, put another way, “How comfortable are you with portfolio volatility and the potential for losses?”.

This is a difficult question to answer, because it is qualitative in nature.  I might describe my risk tolerance as a “high” and so might you.  However, we both may have different interpretations of what a high risk tolerance means.  I might be comfortable with the potential for a big loss, but only if its a remote possibility.  You on the other hand, might be comfortable with a high probability of a moderate size loss.

As you can see, the question is fairly complex and involves contemplating many different scenarios.

The Heretical View: Don’t Ask Yourself About Risk Tolerance

I am going to go against the grain and say that trying to figure out your risk tolerance is counterproductive.  If you are like most people and don’t already have a clear sense of your risk tolerance and how the instruments in your portfolio will behave under different market conditions, you should not attempt to figure it out.

Instead you should either:

 

A Little Knowledge Can Be Dangerous

The point of understanding one’s risk tolerance is to make investment choices which are in line with one’s risk tolerance.  Let’s assume that you decide you have a moderate risk tolerance.  As a result, you look for funds that are categorized as having moderate risk.  You then put your money in 5 different funds that are moderate risk funds.  Have you created a moderate risk portfolio?

There is a high probability that you have not.  Usually, when a fund is described as moderate risk, the description is relative to other funds that make similar investments.  There is no standardized description of what the the term moderate risk means.  A moderate risk fund which invests in stocks will normally have very different levels of volatility and a higher potential for large losses, than a moderate risk bond fund.  What you believe to be moderate risk may not match up at all with the characteristics of a financial product which is described as moderate risk.

 

The Big Problem: A portfolio composed of moderate risk funds can be low risk, high risk, or anywhere in between.

Its not the individual investments, but how they work together, which determines a portfolio’s risk level.  For example, a fund which invests only in large cap stocks, would be described as moderate risk.  However, if that was the only fund in your portfolio, the portfolio would be too concentrated in stocks, and should therefore be considered high risk.

Conversely, a portfolio which only holds a long term investment grade bond fund would also be considered high risk.  In this example the bonds held by the fund would not have a lot of credit risk, but they would have a lot of interest rate risk.  If interest rates move higher then the value of the fund could fall by a substantial amount.

Bottom line: You cannot automatically create a moderate risk portfolio by selecting funds that have been categorized as “moderate risk” by a financial blog or rating service like Morningstar.  A low or moderate risk portfolio is one that balances many different types of risks.

 

Two Solutions: 60 / 40 or Pick A Financial Advisor

Historically, a portfolio comprised of 60% large cap stocks and 40% investment grade bonds has provided 98% the returns of an all stock portfolio, with about one-third less volatility. (You can read more about this here) Essentially, you get the benefits of stock market performance (which has been better than bonds, gold or real estate over the long-term) with much less risk. For most people this is a good portfolio, which will not lead to a bad outcome.

If you want to customize a portfolio to your specific risk tolerance (for example those thinking about retirement may want to do this), I would strongly suggest that you find a financial advisor that create a balance portfolio composed of multiple assets with your risk tolerance in mind. If you would like help with choosing a financial advisor go here.

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