StreetSmarts: Risk Tolerance

Hi everybody, I’m Craig Cairns, President of Howe & Rusling. Today’s episode of StreetSmarts is a really important one to us at Howe & Rusling.  It is the concept of risk tolerance.

In an earlier episode, Sarah Swan talked about Asset Allocation, a topic that is closely tied to risk tolerance, so I’m going to start there. If you recall, Asset Allocation is the strategy of apportioning a portfolio’s funds to various classes, such as the three most common: stocks, bonds, and cash. The purpose of it is to achieve diversification and therefore the different levels of risk and return associated with each of those classes. An individual’s low, moderate, or high tolerance for risk is exactly what drives an appropriate asset allocation—and it’s a sliding and dynamic scale.

Although it is more appealing to think about investing from the perspective of what one might potentially gain, it is also prudent to approach it from a place of what one can and cannot afford to lose. Risk tolerance is referring primarily to that—how much loss a person is willing to withstand if their investments have a bad couple of years. And if history has taught us anything, it’s that market swings happen, economic downturns happen, and generally—losses happen over the near term.  As advisors, we take this part of our job very seriously—making sure our clients’ investment portfolios align with their tolerance for losses, even if that tolerance is emotional in nature, as it most often is.

Now, we pride ourselves on treating our clients as individuals, which means that we do not operate in generalizations. But in order to understand the concept of risk tolerance, some general rules are helpful to understand this thought process. Usually, younger individuals who are gainfully employed and earn a steady income, and have plenty of years ahead of them to grow their assets and even make up for any periods of loss—those individuals are well suited for riskier assets, such as stocks. And that risk of course comes along with the opportunity for higher reward. As those individuals approach retirement age, or the protection phase of their life cycle, though, their tolerance for large swings and periods of loss has presumably decreased—they are likely nearing the end of earning a traditional income stream and perhaps they now need to actually withdraw money from their investment portfolio to replace that income, which is where bonds might be a better fit, or income stocks with a dividend component. The amount of volatility or potential loss these individuals can endure and later make up for is probably inherently lower, given the smaller time horizon. That is why age is one of the predominant factors to drive a person’s risk tolerance, but it is just one of several factors. A person’s investment goals also matter, their level of income matters, as does the presence of other financial assets or income streams, such as homes, pensions, inheritances, or maybe their spouse’s financial situation.

Above any one factor, though, we like to think of risk tolerance as being mostly driven by a client’s individual comfort level. Sure, a person can have a high capacity for risk in the sense that they can financially afford to stomach more loss for the chance of larger gain, but if that person loses sleep over it, they’re probably better suited for less risky investments that don’t cause them undue stress and worry. It’s a very personal decision, and one that we’re accustomed to walking our clients through. We have several questionnaires we can reference to help nail down how a client feels about risk, even if they’re unsure how to identify their own feelings about it. Questions range from “In how many years do you plan to retire” to “Which of the following most describes your attitude about taking on additional risk” to “How much of your current income goes toward paying off debt”? All are important questions whose answers collectively help determine an individual’s tolerance for risk.

The good news is that we have both our own experience as investment managers, and history as a guide, for making prudent asset allocation decisions with our clients, once risk tolerance has been discussed. One of our favorite tools for this process is this historical chart of the returns of various asset allocations over time. Where a person might be inclined to think they need a portfolio of 100% stocks to meet their investment goals, this chart helps put things into perspective a bit. Oftentimes, a small shift away from all stocks, for instance, and into bonds, simply tightens the range in volatility or risk without compromising much in gains.

So looking at the chart, the top row shows an allocation of 90% stocks and 10% cash with the returns from 1950 to 2019.  The first column shows the average annual return and the best and worst years of that allocation.  As you would expect, this allocation has the best average return on the chart—11.86% per year.  However, it also has the most volatility so the way we talk about it with clients is “yes, you might want to maximize your average annual return and an all stock portfolio does that, but do you have the time horizon and the risk tolerance to withstand a year where your 1 million dollars goes to $680,000?”  The flip side of this is a client that wants to shut down all the risk and the chart works to put that situation into perspective as well.  If you go all the way down in the first column to the last row, the chart shows a 90% bond and 10% cash allocation.  This allocation has averaged 5.6% with a worst year of down -9.99%.  However if you walk your allocation up just a little bit to 30% stock, 60% bonds and 10% cash you have increased the average return to 7.69% and actually reduced your volatility and your risk to a worst year return during that time period of -5.79%. 

I mentioned earlier that risk tolerance is dynamic and what I mean by that is that it’s not something we determine one time and never revisit. Risk tolerance, and by extension asset allocation, is something we constantly revisit with our clients, making sure that as their needs, goals, and life circumstances change, their portfolio’s exposure to risk is still a good fit for them. As an active manager, it is our job to be dynamic about asset allocation for our clients, and it’s our job to be in close communication about it.

If you’d like to have a discussion about your own risk tolerance or asset allocation, please do not hesitate to reach out to our team. I hope I’ve made it clear how important this concept is for achieving your financial goals long into the future. Thanks for tuning into StreetSmarts with Howe & Rusling today, and we hope to see you next time.

 

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