Managing Your Risk Tolerance as an Investor

Appropriately managing your tolerance for risk will increase your potential lifetime wealth accumulation.

“Risk tolerance is the amount of risk that you can assume and generally still be able to sleep at night as an investor.”

It is helpful to have a clear understanding as to what your risk tolerance is and how it has implications on your financial planning and investing strategy.

This understanding of risk tolerance is another piece of the puzzle to consider alongside your personal tendencies and behavioral habits.

Depending on your perceptions of risk, the potential payout of taking on more risk may not be worth it. This potential is referred to as marginal utility. The marginal utility of potential payout will most likely differ based on your current net worth. A good way to look at marginal utility is by considering how much additional enjoyment or happiness you would experience from an extra $500, $1,000, or (x) dollars that you stand to gain.

Individuals that tend to be more risk-averse, usually don't gain as much marginal utility from the ability to spend an extra $500 to $1,000 when compared to risk tolerant individuals.

This then is applicable to your investment portfolio, as generally the more risk you take on the greater the variability in payout down the line and horizon. This variability is greater in magnitude in gains as well as loss, as it may mean future payouts will either result in higher future spending or a much lower ability to spend.

One's net worth plays a role in this evaluation, as a high-net-worth individual has a higher probability of being able to have a greater loss and still meet their day-to-day needs. The concept of loss aversion and impact is more severe in say a 25% loss from a portfolio worth $100,000 than that of $10 million.

Increasing your financial literacy and knowledge will positively change your ability to more accurately gauge the degree of variation in assumed risk. As financial literacy decreases so does the ability to gauge risk outcomes, and herein lies the importance of staying engaged with your financial planning.

Personally, I lean more on the end of the spectrum that embraces risk more so than being risk averse. This is not due to net worth, as I am managing my educational debt acquired thus far, but more so because I still have a longer investment timeframe.

Although there are tools that allow us to model risk, there are many factors and considerations that only you can determine. The following are some tips on how to navigate through the more common ones:

Consider your family:

  • Financial decisions are best when they are aligned with your family’s values and understanding. Finances have long been identified as a leading cause of stress in households and relationships.
  • Maintain an open dialogue by involving the entire family during financial discussions. Additionally, being careful in your choice of words can make the difference in getting buy-in from everyone involved. For example, if using the word “budgeting” invokes a sense of negativity/restriction, it can be easily refrained to a “spending plan” or “spending goals” and still mean the same thing.
  • In LEAN, there is the concept of Visual Management that I think is very applicable in these situations as well. Visually depicting financial plans for goals whether that is a future home, or vacation, simply having a visual somewhere everyone can see it on a regular basis in the home will help visually manage expectations and the why the family is working together to reach a set goal.

Consider your goals:

  • What are your long-term financial goals?
  • How do you view your current work?
  • When would you like to reach your point of financial independence?
  • Are you working to retire early or intend to work for the majority of your eligible working years?
  • Are you currently on track to reach my goals? If not, what needs to change?
  • What would you need to live on and still be happy?

Consider your time frame:

The time you have to take risk is also an important consideration as the more time you have until retirement the more risk tolerant you can and in many instances should be.

  • Short Term: Generally less than three years; The closer you get to your goal the less risky you want to be with that money. In this time frame more liquid investments or cash equivalents would fit well. Others like opening CDs that have a defined time frame, an idea that also works well.
  • Mid Term: Three- to 10-year range; These are the goals for which you may still need to accumulate the funds or you aren’t yet ready for but plan on pursuing down the line. The more time you have, the more risk tolerance you can afford to have.
  • Long Term: More than 10 years; These goals are generally in planning for retirement where you will have to draw on your investments and adequately live for 20 to 40-plus years following retirement. This frame also allows your portfolio to be riskier and allocate the majority to stocks and allowing time for compounding.

Approach risk from an evidence-based perspective:

  • One thing to embrace is maintaining objectivity when taking on risk. There are many ways to optimize your portfolio through diversification, such that it aligns with an adequate level of risk that allows you peace of mind but maintains age appropriate risk.
  • In addition, you can achieve better management and control by doing your research and staying engaged in your financial planning.

Follow @ChiwesheMD