A Practical Approach to Assessing Investment Risk Tolerance

Try to think about what you ultimately want to do with your investment returns, within realistic limits.

Dentists’ mentality is about risks and outcomes. Whether the job at hand is preventive care, diagnosis, treatment or surgery, a dentists unerring focus is on the risks involved in what they do or don’t do.

Yet many dentists stray from this outcomes-based mentality when considering investment risk. An investor’s risk tolerance is a key factor in determining the asset allocations of an investment portfolio. If you take too much risk, by purchasing investments with high potential returns but a high potential downside as well, this could jeopardize goal achievement and keep you awake at night. On the other hand, if you take too little risk, you could end up forgoing potential returns and sacrificing progress toward reaching your investment goals. Thus, taking too much or too little risk can both lead to the same undesirable outcome.

So how do you assess your risk tolerance? The internet is awash in questionnaires that purport to help you do this. If you have a financial advisor, chances are you’ve filled out such a questionnaire at the outset of the engagement. These questionnaires typically ask how you’d feel if investment markets went down by x, y and z percentages — so you pondered each prospect and gave your best answer.

Unfortunately, this method may not get at your true risk tolerance because it’s too abstract, too theoretical. A more effective way is to take the same approach you do with your patients, one that’s based on outcomes.

By this, I mean real outcomes, like your patients’ health as a result of your diagnosis and treatment. The parallel for your financial outcomes is whether you’re able to achieve the life goals you’re seeking to fund through your portfolio’s returns—and how you’d feel about falling short of these goals.

Here are some points to consider:

• Your portfolio’s risk level is determined by the potential risk and returns of specific investments chosen for it. As the guiding parameter here should be your risk tolerance, getting the right fit may mean lower returns for the fearful and potentially higher returns for the truly brave. It’s all about how much risk you can handle emotionally. The whole idea is to build wealth sanely by aligning your portfolio with your true emotional capacity for risk.
• An outcomes-based approach considers how you’d feel if you failed to achieve key goals. Just about everyone (except the obscenely wealthy) invests for retirement. The pertinent issue for most investors is: What kind of lifestyle will you have during retirement? Let’s say you plan to keep your home and buy another home in a different region or country. Let’s also say you plan to keep your country club membership and take 5 or 6 trips abroad every year. What if your investments to fund these goals divebombed in a market crash and rebounded with excruciating slowness? How would you feel if this meant you couldn’t afford the new home? The trips abroad? The club membership? These outcomes would probably have real emotional consequences.
• Retirement planning may not be your only goal for investing. If you’re investing for your kids’ college educations, how would you feel if you could only afford to send them to a state university instead of the private schools you’d planned on? What if you couldn’t buy the summer home you’re counting on acquiring while you’re still practicing? Assuming you have such interim goals covered, what if market events meant that you couldn’t leave your kids the legacy you’d planned to?
• Understand that such disappointments can come either because you took too much risk or not enough. Those with portfolio risk levels lower than their actual tolerance may still achieve some of their goals, but they could be forgoing returns (needlessly, as they could handle the associated risks) that would take care of others. For these people, the issue isn’t emotional stress; it’s not getting where they realistically planned to go.

So instead of pouring over questionnaires, try doing some hard thinking about what you ultimately want to do with your investment returns, within realistic limits, and how you’d feel if you failed to real these goals. This won’t just indicate how much risk you can tolerate in your portfolio. It will also tell you a lot about yourself.

Eric C. Jansen, a Chartered Financial Consultant, is the founder, president and chief investment officer of Westborough, Mass.-based AspenCross Wealth Management, which provides fee-only financial planning and investment management services for high-net-worth clients nationwide.

The information presented is not intended as financial advice, and you are encouraged to seek such advice from your financial advisor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money. Diversification/asset allocation does not ensure a profit or guarantee against loss. Registered representative/securities and investment advisory services offered through Signator Investors, Inc. Member FINRA, SIPC, and Registered Investment Advisor. AspenCross Wealth Management is independent of Signator.