Why You Can’t Measure Your Own Risk ToleranceSubmitted by Tidemark Financial Partners on August 6th, 2018
Nearly all the mistakes made by investors can be attributed to the mismanagement of risk due to misunderstanding risk, underestimating or overestimating risk, disregarding risk, miscalculating risk, or the failure to consider all forms of risk. Long-term investing, with the goal of accumulating sufficient capital to secure a lifetime of income in retirement, requires proactive risk management and a firm understanding of the relationship between risk and returns.
Most investors understand that the higher the returns they seek, the greater the risk they should be willing to assume. Less understood is the role risk plays in generating higher returns – that without risk there is no opportunity to earn higher returns. Investor should know their optimal level of investment risk before choosing their investments.
What Exactly is Risk Tolerance?
Your risk tolerance is your emotional capacity to endure negative returns in exchange for the potential to earn positive returns. Your risk capacity is your financial capacity to withstand losses. You may have the financial capacity to withstand negative returns, but you may not have the stomach for it. That is why risk tolerance is a critical factor in making investment decisions.
How Do You Measure Risk Tolerance?
Measuring risk tolerance is not an exact science. While you can go online and complete a risk tolerance questionnaire (RTQ), it may fall short of providing an accurate measure. Questions like, “how would you react if the market suddenly declined by 20%?” may give you some understanding of how you are likely to behave during a risky event; however, answering such a question when you are calm and relaxed might produce a different answer when you are in the reality of a severe market decline. To score your answers on a universal RTQ, the creators have to use some arbitrary reference points, which don’t consider the variables from one investor to the next.
For example, an RTQ can’t gauge risk composure, which is the level of influence fear or greed can have on an investor’s risk tolerance. Intellectually, you might think you can withstand a 20% drop in the market but, if you are overcome with fear when it happens, you are more likely to sell in a panic. Your risk perception can also skew your investment decisions. If your current perception is that all is well in the market, you may feel as though you can tolerate more risk. These are separate risk variables that, if not understood, could cause you to introduce too much or too little risk into your portfolio. These variables need to be rolled up into a more complete risk profile that can help you determine a realistic risk and return expectation, which is how you determine your asset allocation.
You Need an Independent and Complete Risk Assessment
Trying to assess your own risk tolerance is akin to assessing your own health. You are limited by your knowledge level and influenced by your biases, which can skew your findings. For the same reason you would want a medical professional to assess your health, you should have an independent financial advisor assess your risk tolerance as part of a more complete risk profiling process. He or she has the investment expertise to match your risk profile to an appropriate investment strategy with realistic risk-return expectations. That is what gives you the confidence to ignore your emotions and stick with your strategy, which is the key to achieving positive long-term performance.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.