I’ve written many times before about investment risk – and what you need to do about it.
You’ve gone to the net or worse met with an adviser – who asked you or sent a questionnaire with 30 multiple choice questions like:
If my investment portfolio begins to drop in value, I will
a) sell all of it
b) sell some of it
c) hold and do nothing
d) invest more into the portfolio
When making an investment, I plan to keep my money invested for
13+ years……………..or even longer time frames.
Generally, I prefer investments that
have a higher potential for return even if their value can fluctuate widely and create a permanent loss
have a lower potential for return in exchange for less variability in value
have little potential for return and little fluctuation in value – I know that inflation might hurt my portfolio
What these questionnaires are designed to do is ask you to determine your tolerance for risk.
In other words, how much “pain and suffering” are you willing to experience with your investments in exchange for the promise of returns? Largely they are asking how much of risk are you willing to take…
Some of the robo or human advisers might may want to build a portfolio for you that will give you the max level of risk for your stated level of tolerable risk. Their recommended portfolio will also have minimum amount of risk for a stated target investment return. Of course it is just a guess, but hopefully a well educated guess.
Should you build your life around risk? risk tolerance? risk vs return calculators….?
See Need not just Tolerance..
Your advisers should consider your need for risk.
So rather than focus on your risk tolerance which is derived from a set of multiple choice questions, I think the better approach is to focus on your need to take risk.
So how do you determine your personal need for risk? It all begins with your financial plan.
Only after quantifying and recording your values, goals, and priorities can we begin to build your financial plan. Once the plan is ready we can test your requirements, and then we can then begin the process of understanding how different levels of investment risk impact the confidence level in your plan.
POSSIBLY, BUT NOT SURELY, in many cases, taking more risk over time will lead to higher net worth down the road. But are you wanting and able to stomach the volatility that is associated with higher risk and stick with your plan through bad times?
Do you need to take the additional risk for the hope of a better future, or can you achieve your goals with a lower level of risk?
Lets say you plan to retire at age 60 and spend Rs. 600,000 per year in retirement. Lets see whether it is realistic.
We have 3 variables to look at when we stress test:
- Cash flow – expenses and income
Time represents the timing of your goal.
Cash flow represents your savings, investing, income and spending. You’re probably saving money through Pf, ppf, or into a savings account at your bank. Once you retire – you will move from accumulation mode to withdrawal mode. How much you are saving or spending is captured in the idea of cash flow.
And finally, risk is determined primarily by how you allocate your investment portfolio among shares, bonds and cash.
Now, let’s imagine that 2 days after your 54th birthday, your husband experiences some severe health issues that have you considering an earlier retirement so you can help care for him and spend more time with him before his health worsens.
Here are your choices:
- Retire sooner by spending less in retirement
- Retire sooner by taking more investment risk
- Retire doing a combination of 1 and 2
- Assuming you’re currently investing money, you could also consider saving/investing more to help support an earlier retirement.
After evaluating the choices above, you elect to take on more investment risk in your portfolio to help make an earlier retirement a reality.
But then, just 2 months later, your husband makes a recovery and his health condition is perfect and he starts earning again – as if nothing ever happened.
While you may still want to consider retiring earlier, let’s assume you enjoy your work and your colleagues and revert back to your retire at age 60 and spend Rs. 600,000 in retirement goal.
Here’s the Big Question in Determining Risks
– should you keep your investment risk at the higher level based on the prior, early retirement assumption?
In raising your risk, you clearly demonstrated a “tolerance” for higher risk.
If you plan to scrap the retire early scenario (age 54) and go back to working until age 60 (or even get a 2 year extension), assuming nothing else has changed, you’re now taking risk that you don’t need to expose yourself to.
The only reason you’d leave your risk at the higher level would be if you wanted to spend MORE than 600,000 per year in retirement or you had other goals you had cut out because of the medical emergency?
Should you add goals JUST because you suddenly feel that your risk tolerance is higher?
These questions YOU alone have to answer – your planner should just be asking these questions.
One of these might be that you may spend a little more NOW and invest less from your current income. Higher investment risk might make this possible.
Of course for the sake of this post I have used a simple variable. In real life there could be more variables and answers may not be so simple or straightforward. For most people risk is not so simple and easy to understand. A fluctuating market can make them jittery and nervous and may not stay the full course. So the questionnaires are not exactly useful. Risk should be determined based on your need to take risk instead of basing it only on your personal pain threshold. But you can’t fully explore and determine your need in the absence of a comprehensive financial plan. Even in the plan your assumptions keep changing!!
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