How to Gauge Your Risk Tolerance

August 05, 2014

Connect Member

Certified financial planner, certified divorce financial analyst and estate planning specialist

I can recall the day vividly. 

“This is like the other ones I’ve been on, right?” I asked my dad.  

“Sure,” he replied, “You’ll love it!”  

I sat next to my father, a hesitant smile on my face, as the man fastened the safety bar over our laps. Our string of carts ascended a long hill, paused for a moment, then plunged into a special type of hell that involved plummeting, skyrocketing intermittently and being jerked around sharp corners in between. Busch Gardens called it “The Big Bad Wolf.” I called it the worst experience of my life at a theme park. My brother called it “rad” and happily ran back in line for a second round while I clung to my mother’s side.  

Ah, roller coasters. Some people love ‘em, others not so much. The moral of this story as it applies to investing is: Before you jump in, know your tolerance for ups and downs and what type of ride you’re signing up for.

Each day, I have discussions with clients, friends and even strangers about the market. The ebbs and flows of the stock market are fun to comment on and can be alluring to investors wanting to make their money grow. If you want to know a secret to investing success, I can summarize it in one word: Risk.

See, it’s not so much about loading up on today’s hot stock then off-loading it at the right time. The key to investing success is in managing your risk. 

Here are four questions to ask yourself (and your financial planner) to get you on the right track to success:

1.  What is my risk tolerance?

It’s easy to be aggressive in an up-market year. After 2013’s exciting return of over 30 percent for the S&P 500, many investors are eager to be on the stock band wagon. However, it’s important to know how you’d feel if we had a market correction of over 10 percent in the next year or so. Would you still like to be all in, or would you lose your lunch reading your investment statement? 

Another way to think about it is this: If you have a $100,000 portfolio that loses 20 percent in one year, then you’re down to $80,000. In order to get back up to $100,000, you’d have to earn $20,000, or 25 percent, in the following year to come back to your starting point. If you only lost 10 percent in one year, down to $90,000, then you’d only have to earn $10,000, or 11 percent the next year to come back to your starting point.   

The amount of risk you take on can make it more difficult for your portfolio to climb back from a plunge. If you’re OK staying in the market and can endure a longer comeback, it may be worth it to get into a more aggressive strategy. 

Your time horizon can also help you determine how much risk you should have in your portfolio.  Your time horizon is how long you have to invest your portfolio until you need to liquidate it. For example, if you have money to invest but want to take it out to buy a house in five years, your time horizon is different than if you’ve got an IRA to invest, but aren’t going to take distributions out for another 25 years. The longer the time horizon, the more time you have to bounce back from a market decline. 

2.  What risks are in my investment portfolio?
There are all kinds of risk out there. There is no way to have risk-free investments, despite what infomercials might promise you. If you’re investing, there’s always some risk involved (I know, I sound like Debbie Downer, but it’s the truth!). Here are a few risk-related terms to get familiar with:

  • Standard Deviation — This is the volatility of your portfolio. It’s the range of returns about two-thirds of the time. Generally, if your portfolio has a standard deviation of 10 percent, and an average return of 5 percent, then two-thirds of the time, your returns will be between -5 percent and +5 percent. 
  • Beta — This tells you how your portfolio will move in comparison with the market. The higher the beta, the more your portfolio will move along with the market. For example, if you have a beta of .70 compared with the market, then you’d generally expect it to be about 30 percent less volatile than the market (it would go up about 70 percent of the market and down about 70 percent of the market). A beta of 1.3 would mean you’d expect it to be about 30 percent more volatile than the market.
  • Sharpe Ratio — This is the risk-adjusted return of your portfolio. Ideally you want the Sharpe ratio of your portfolio to be higher than your benchmark (the index that you compare your portfolio to).  Even if one fund or manager has a higher return than another, Manager A can add higher risk assets to produce a higher return than Manager B, but Manager B may have a higher Sharpe ratio, meaning that Manager B has a better risk-adjusted return.
  • Credit Risk — Think of two friends you may have — one is a total party girl who crashes on couches and never has enough cash to pay her own way, and the other is a successful, stable lady who has been saving her money and investing it wisely since you were little kids. They both want to borrow money from you, with interest. Which one would you want to loan the money to? Probably not the couch crasher, and if you did loan it to her, you’d probably charge a high interest rate because you’d be afraid you’d never see the cash again. 

Apply this to bonds, and you can see the difference between, say, a AAA grade corporate bond and a high yield or junk bond. Really strong companies like Apple don’t have to pay bondholders high interest rates because, well, you know they’re gonna pay it back. Smaller companies or companies that have some risk of possible default usually pay a higher interest rate. This doesn’t mean you shouldn’t have higher yielding bonds; just know that there is some risk in owning these bonds. Weigh it out: Are you being properly rewarded for the risk you’re taking on?

Interest Rate Risk —  When interest rates go up, bond prices go down. Bonds are funny animals: their prices and rates move inverse to each other. What I mean by this is that if a $100 bond is paying you 5 percent per year, or $5 per year, and rates jump up and you can get a bond that pays 10 percent, or $10 per year, if you try to sell your 5 percent bond, no one will want it. So you’d have to sell it at a discount, probably until it was paying out 10 percent too. The price would have to fall to $50 in order for that to happen, so as the yield goes up from 5 percent to 10 percent, the price has to go down. When rates go up, then most of the existing bonds will be pretty unattractive, so you would have some interest rate risk on anything that has rate sensitivity. This includes bonds, preferred stocks, higher dividend paying stocks and real estate investment trusts.

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