The consequences of “financial risk” became apparent to many investors during the a two-year period from 2007 to 2009. The stock market (as measured by the Standard & Poor 500) plummeted from 1562.47 on October 10, 2007 to 752.44 on November 20, 2009. As a consequence, more than one-half of the retirement savings of many people were lost.
Many investors had saved money for years in order to enjoy a comfortable retirement – but as a result of the decline in stock values in that two-year period, workers were forced to delay retirement or accept a significant decrease in their expected standard of living. The S&P 500 did not regain its previous high level until the first week of April 2013.
What Is Risk?
Even though all human endeavors have a measure of risk, human beings have a hard time understanding and quantifying “risk,” or what some call “uncertainty.” Many of us understand that risk is the possibility of loss and it is omnipresent. There is no certainty that you will live beyond the day, drive to the grocery store without an accident, or have a job at the end of the month.
Risk exists when we take action or, conversely, when we fail to act. It can be as obvious as driving while intoxicated, or as unforeseen as an earthquake striking in the Midwest.
Most people are risk-adverse. Essentially, we prefer the status quo, rather than dealing with the unknown consequences of new endeavors or experiences. This is particularly true in financial matters, and is evident in the correlation of price and perceived risk: Investments considered to be higher risk must pay higher returns in order to get people to buy them.
The degree of risk in a financial asset is generally measured by the asset’s price variability or volatility over a period of time. In other words, a common stock that ranges from $10 to $20 a share over a six-month period would be considered to be a higher risk than a stock that varied from $10 to $12 during the same period. Practically speaking, the owner of the more volatile stock is likely to worry more about his investment than the owner of the less volatile stock.
Risk Tolerance Is Personal
How we perceive risk varies from person to person, and generally depends upon an individual’s temperament, experience, knowledge, investment and alternatives, and time for which he or she will be exposed to the risk. Risk itself is generally categorized by its likely impact or magnitude if the uncertain event happens, as well as its frequency or its probability of occurring.
Many people purchase a $1 lottery ticket with a payoff of $1 million, even though their loss is virtually certain (10,000,000 to 1) because the $1 loss is not significant upon living standard or way of life. However, few people would spend their month’s salary on lottery tickets since the probability of winning would not significantly increase. At the same time, many people are willing to invest unlimited amounts of their savings into U.S. Government Treasury notes since the likelihood of their repayment is considered certain (1 to 1).
When humans exceed their risk tolerance, they show physical signs of discomfort or anxiety. To a psychologist, anxiety is those unpleasant feelings of dread over something that may or may not happen. Anxiety differs from actual fear – a reaction when we encounter a real danger and our body instantaneously prepares an immediate fight or flee response. To a lesser degree, anxiety triggers similar physical reactions in our body, even though the danger may be imagined or exaggerated.
Being anxious over any extended period is physically debilitating, reduces concentration, and impairs judgment. For these reasons, it is important to identify your personal risk tolerance as it applies to different investments, since exceeding that tolerance is most likely to end with disappointing (or even harmful) results. Reputable investment advisors frequently tell their clients, “If an investment keeps you from sleeping at night, sell it.”
There are several questions you can ask yourself to help gain an understanding of your personal risk tolerance. Remember that there is no “right” level of tolerance or any necessity that you should be comfortable with any degree of risk. People who appear to take extraordinary risk financially or personally have most likely reduced the risk (unbeknownst to observers) with training, knowledge, or preparation. For example, a stunt car driver expecting to be in a high-speed chase will use specially engineered autos, arrange for safety personnel to be readily available in the event of a mishap, and spend hours in practice, driving the course over and over at gradually increasing speeds, until he is certain he can execute the maneuver safely.
Questions to Ask Yourself Regarding Risk Tolerance
1. How Much Money Will You Invest?
Investing is not gambling where you either win or lose on the basis of chance – it should be the research-based, directed purchase of specific securities intended to provide a specific return. However, estimating the amount of funds you will invest over a period of time can provide a real basis for making investing decisions and accommodating your risk tolerance.
During your lifetime, you will pay for your family’s living expenses, healthcare costs, possibly college tuition, and finally, retirement expenses. Realistically, you may save at most 10% to 12% of your income over the period. This is, more or less, the money you will have to invest over your lifetime to cover possible college and retirement expenses.
Why is this number important in understanding your risk tolerance? When your college buddy offers a sure-fire investment deal guaranteed to double your money in five years, recognize how it will impact your overall picture. A $5,000 investment has different consequences if you are 35 with years of potential raises and promotions ahead of you than if you are an older employee expecting to retire in five years. The younger person may be able to tolerate the risk of a total loss, while the older investor recognizes that $5,000 is real money.
2. How Much Money Will You Need?
People generally save for a specific purpose, whether it is to pay for college or to maintain their lifestyle when they quit working. Have you considered what you will do with your accumulated savings and how much you will need to meet your objectives?
Suppose you are saving for retirement. Most financial advisors calculate that a retiree needs 70% to 75% of his or her pre-retirement income to maintain the same lifestyle. Using an average income of $72,000, you will probably need a minimum of $50,000 a year after you retire. While some income will be collected from Social Security (barring major changes), your savings and any employer benefit plans will be necessary to make up the difference.
A rule of thumb for safely withdrawing funds from an equity account without depleting principal too quickly, popular in the financial community for years, is 4% of fund balance. In this example, using 4% as the withdrawal percentage (which has come under attack due to market performance in the last decade), you would need $1.25 million when you retire to live as you expect (according to average life expectancy).
Whether these specific examples are indicative of your needs is less important than calculating your future financial needs as early as possible. That amount, when compared to your likely saving rate, can help you identify the investment gap you need to close if you are to reach your goals.
3. When Will You Need It?
Investment values generally compound over time – the longer your money works for you, the greater the ending balance at a steady rate of return. For example, investing $100 per month at 5% per annum will build a savings of $15,728 in 10 years. At 20 years, the balance will grow to $41,820, and in 40 years, $156,212. Your investment during the period is $48,000. Clearly, time is on your side.
The value of your ending account is the result of your investment ($100 per month, in this case), your earning rate (5%), and the investment period (40 years). For example, if you raised your investment to $200 per month over the 40-year period, the ending account balance earning at the same rate would be $312, 424. On the other hand, continuing to invest $100 per month for the same 40-year period and increasing your average rate of return to 8% (from 5%) would produce an ending balance of $293,268.
How does the length of investment period affect your risk tolerance? Given the same investment and the same accumulated balance needed, time and required earning rate are inversely correlated: The shorter the investment period, the higher the earning rate must be to produce the desired accumulated balance with the same investment. If you calculate that you need $150,000 in 30 years (rather than in 40 years, as in the example above), you would need an average earning rate of more than 9.5% per year – almost double what a 5% rate would produce over 40 years.
Higher returns are associated with greater risk and more volatility in your investments. According to a 2013 report by Thornburg Investment Management, nominal returns (before taxes, inflation, and expenses) for a 30-year period ending December 31, 2012 for U.S. Treasury bills (the safest investment) were 4.3%, while U.S. Large Cap stocks returned 10.8% during the same period. Practically speaking, the shorter your investment period, the more likely you will need to invest in higher risk assets to achieve your desired objective. And that is where your risk tolerance comes into play.
4. What Are the Consequences of a Gain or Loss?
Anxiety levels are directly related to the importance of the outcome. If you are lucky enough to have a secure pension which – combined with Social Security payments – will produce a comfortable retirement, you are less dependent upon your personal investment results than if you had no guaranteed pension. As a result, you could invest in higher risk assets since a loss would not be devastating.
Unfortunately, more people are dependent upon their savings for an adequate retirement than those who are not. This dependence means that the pressure to achieve consistent returns is much greater, and therefore, taking greater risk is likely to cause anxiety.
The bottom line is that many people are caught between the proverbial rock (the need to achieve a specific retirement fund balance) and a hard place (the requirement to invest in higher risk assets in order to reach their retirement objective). Since you are likely to need to use higher-risk investments that make you uncomfortable, the practical solution is a compromise between lowered expectations and your ability to increase your risk tolerance as much as possible.
5. How Can You Change Your Risk Tolerance Level?
The perception of risk is different for each person. Just as the stunt driver prepares for an apparent dangerous action in a movie or an oil man selects a place to drill an exploratory well, you can manage your discomfort with different investment vehicles. Learning as much as possible about an investment is the most practical risk management method – investors such as Warren Buffett commit millions of dollars to a single company, often when other investors are selling, because he and his staff do extensive research on the business, its management, products, competitors, and the economy. They develop “what if” scenarios with extensive plans on how to react if conditions change. As they grow more knowledgeable, they become more comfortable that they understand the real risks and have adequate measures in place to protect themselves against loss.
Diversification is another popular risk management technique where the assumption of risk is unavoidable. Investors can reduce the impact of a potential disaster by limiting the potential of loss. Owning a single stock magnifies the opportunity for gain and loss; owning 10 stocks in different industries dilutes the effect of one’s stock movement upon the portfolio.
If you cannot reach your investment objective by limiting your investment in only “safe” assets, you can limit the potential of loss while exposing your portfolio to higher gains by balancing your investments between safe and higher-risk investment types. For example, you might keep 80% of your portfolio in U.S. Treasury bills and only 20% in common stocks. This potentially provides a higher return than a portfolio invested solely in Treasury bills, but protects against losses that might result in a 100% equity portfolio. The proportion of safe to higher risk assets depends upon your risk tolerance.
Accumulating significant assets takes equal measures of the following:
- Discipline. Diverting current income from the pleasures of today to saving for tomorrow is not easy. Nevertheless, it is essential if you want to reach your future objective.
- Knowledge. Expending the effort to understand different assets and how they are likely to perform in changing economic environments is necessary if you are to select those investments that will deliver the highest return with the lowest risk.
- Patience. While “good things come to those wait” is a popular advertising slogan, it is especially applicable to investing. The benefit of compounding interest accrues to those who can wait the longest before invading the principal (spending any of the accumulated assets).
- Confidence. Being able to manage your risk tolerance effectively – understanding which investments are worthwhile and which to avoid – is required in a complex investment environment. Self-knowledge allows you to understand why some investments make you anxious and how to proceed to differentiate between perceived and real risk.
We live in a complex, confusing world that is constantly changing. Fortunately, humans are especially adaptive to survive and thrive in the chaos that surrounds us. While there are real dangers, there are also great opportunities. Selecting investments may be less adventuresome than fleeing from hungry lions, but managing your fear and selecting the best strategy is critical for each.
What additional methods or questions may help a person determine his or her risk tolerance?