Understanding Risk: Your Tolerance, Capacity, and Perception
If you’re reading this, you probably already know that managing risk is crucial to your financial well-being. You’re on a financial planning website after all! You likely also know that your investment portfolio should reflect your unique circumstances, goals, and risk profile.
What you might not be familiar with is that the key to making the most of your hard-earned money is understanding the difference between risk tolerance, capacity, and perception — and how they intersect. In this blog, I’ll delve into these concepts and explore how they can impact your investment decisions.
Your Risk Tolerance: The Emotional Side
Tolerance is the level of risk that you’re comfortable with in your investment portfolio. It’s a subjective measure based on your feelings and emotions regarding potential investment losses. Everyone’s risk tolerance is different and can be influenced by factors such as age, financial knowledge, and investment experience.
Understanding your risk tolerance is essential to building an investment portfolio that aligns with your financial goals and personal comfort level. As the Director of Investment Planning at Financial Planning Fort Collins, I take both objective and professionally subjective assessments of each client’s risk tolerance.
To objectively measure risk tolerance, I like to use a questionnaire with an output that we can easily understand by comparing the result to a baseline range of outcomes. Each person’s understanding of “aggressive” may be completely different, but we’re much more likely to understand “90 out of 100” in a similar way if we know that 100 represents risk similar to gambling and 1 represents no investment risk at all.
To further assess risk tolerance, I like to also have in-depth discussions with each client to determine variables that even the best objective assessment can miss from time to time. This more subjective approach can include evaluating factors like time and timing, as well as how risk capacity and perception may be influencing risk tolerance. More on those soon.
There are three primary categories of risk tolerance:
1. Conservative: Investors with a conservative risk tolerance prefer to avoid significant losses, even if it means accepting lower returns. They often gravitate towards low-risk investments such as bonds and cash.
2. Moderate: Moderate investors are willing to accept some risk for the potential of higher returns. Their portfolios often include a mix of both lower-risk and higher-risk investments.
3. Aggressive: Aggressive investors are willing to accept substantial risk for the potential of outsized returns. They often invest heavily in high-risk assets, such as stocks and other growth-oriented investments.
It’s essential to recognize that your risk tolerance can change over time. As you age or gain more investment experience, you may become more comfortable with risk or find that you prefer a more conservative approach. Reassessing your risk tolerance regularly ensures that your investment strategy continues to align with your personal preferences.
Pro Tip: We offer investment planning consultations every July. Ready to get yours on the calendar? You can schedule a convenient time here. And you can request a risk tolerance questionnaire at any time. We’ll send you a unique assessment link along with a calendar link so we can discuss your results.
Your Risk Capacity: The Financial Side
Capacity is the financial ability to withstand investment losses without jeopardizing your long-term financial goals. It’s an objective measure based on factors such as your income, assets, liabilities, and investment time horizon.
Having a high risk capacity means you can afford or are able to take on more risk in your investment portfolio. On the other hand, a low risk capacity suggests that you should be more conservative with your investments to avoid jeopardizing your financial security.
Consider a 40-year-old professional with a high income, significant assets, and a long investment time horizon. This individual likely has a high risk capacity and can afford to take on more risk in their investment portfolio. However, if they have a conservative risk tolerance, it’s essential to balance their emotional comfort level with their financial ability to withstand risk. This is where risk tolerance and risk capacity meet.
Your Risk Perception: How You View It
Perception is how you view and interpret investment risk. It’s influenced by personal experiences, cognitive biases, and emotional reactions to market fluctuations. It can even come down to your attitude toward risk on the day that you complete your risk assessment or how you’re feeling when we meet to discuss your portfolio! Risk perception can significantly impact your investment decisions and lead to irrational choices based on fear or greed.
For example, during a market downturn, some investors may panic and sell their investments, fearing further losses. Their risk perception often drives this decision, even if their risk tolerance and capacity suggest they should remain invested. On the other hand, during a strong market, investors may become overly confident and take on excessive risk, chasing high returns without considering the potential consequences.
Here are just a few of the common cognitive biases that can affect your risk perception:
1. Recency Bias: This bias occurs when you give more weight to recent events than historical data. For example, if the stock market has been performing well recently, you may perceive investments to be less risky than they actually are.
2. Confirmation Bias: This bias leads you to seek information that confirms your existing beliefs and ignore information that contradicts them. If you believe that a particular investment is low-risk, you may focus on positive news about that investment and disregard negative information.
3. Loss Aversion: This bias refers to the tendency to feel the pain of losses more acutely than the pleasure of gains. It can lead you to be overly conservative in your investment choices, avoiding any potential losses even if it means sacrificing higher returns.
It’s essential to be aware of risk perception and work to neutralize it when making investment decisions.
The Role of Diversification
Diversification is a critical component of effective risk management. It involves spreading your investments across a variety of asset classes, sectors, and geographic regions to reduce the impact of any single investment on your overall portfolio. By diversifying your investments, you can mitigate (but never eliminate) the risks associated with specific investments and create a more stable long-term investment strategy.
Here are some key principles of diversification to consider:
1. Invest in different asset classes: Asset classes — such as stocks, bonds, and cash — tend to respond differently to market conditions. By allocating your investments across various asset classes, you can reduce the impact of fluctuations in any one class on your overall portfolio.
2. Diversify within asset classes: Within each asset class, invest in a range of individual securities, sectors, and industries. For example, within the stock portion of your portfolio, you might invest in companies of various sizes, across different industries, and from different countries.
3. Rebalance regularly: Over time, market fluctuations can cause your portfolio’s allocation to drift away from your target. Regularly rebalancing your portfolio — selling investments that have performed well and buying those that have underperformed — can help maintain your desired level of risk and return. Your target investment mix doesn’t change simply because some things did better or worse than others.
4. Consider alternative investments: In some cases, alternative investments such as real estate, commodities, or private equity can provide additional diversification benefits and potentially enhance your overall portfolio returns.
Incorporating diversification into your investment strategy can help you manage risk more effectively and improve the long-term performance of your portfolio. One perk of working with FPFoCo is that your investment management is included. That means you can leave your portfolio to us! We’ll develop a diversified investment strategy tailored to your unique risk profile and financial objectives. Then, we’ll implement it and rebalance your portfolio for you on a quarterly basis.
Beyond Investments: A Comprehensive Approach to Financial Risk Management
While managing investment risk is essential, it’s also important to consider the broader financial risks you may face. Let me explain what some of them are and what they mean …
1. Inflation: The purchasing power of your assets declining over time due to rising prices
2. Interest: Changes in interest rates negatively affecting the value of your fixed-income investments or increasing your borrowing costs
3. Tax: Changes in tax laws or regulations adversely impacting your financial situation
4. Longevity: Outliving your assets and facing financial hardship in retirement
5. Liquidity: Being unable to convert an asset into cash quickly and without significant loss of value
6. Legal and regulatory: Financial loss due to changes in laws, regulations, or legal proceedings
7. Business and professional: Financial loss due to challenges or changes in your professional or business activities
Keep in mind that these are risks, meaning that they could happen — or they might not.
Bringing It All Together: A Holistic Approach
Understanding your risk tolerance, capacity, and perception is crucial for building an investment portfolio that meets your unique needs and goals. By considering all three aspects of risk, you can create a balanced investment strategy that reflects your emotional comfort level, financial situation, and an objective assessment of potential risks and rewards.
Since your investment plan is an important piece of your overall financial plan, we’ll want to review it together annually. As a part of the review, we’ll …
1. Assess your risk tolerance with a questionnaire, then have an in-depth conversation to understand your emotional comfort level with investment risk.
2. Evaluate your risk capacity by reviewing your financial situation, including income, assets, liabilities, investment time horizon, goals, and more to determine your financial ability to withstand risk.
3. Discuss your risk perception and address any cognitive biases that may be influencing your investment decisions.
4. Build a personalized investment portfolio that aligns with your risk tolerance, capacity, and perception, helping you achieve your financial goals while managing risk effectively.
5. Regularly review and adjust your investment strategy to ensure it continues to align with your evolving risk profile and financial objectives.
By taking a more well-rounded approach to risk management, we can help you build a resilient investment portfolio that supports your long-term financial success.
Pro tip: If you’re ready to explore how our personalized approach to financial planning can help you achieve your financial objectives, please reach out to us to schedule a consultation. We’re excited to be a part of your journey and look forward to helping you build a secure financial future.
Not a client yet? See if our ensemble approach is right for you.
Not a client yet? See if our ensemble approach is right for you.