December 28, 2009


The turbulent stock market of the past two years has investors and financial planners alike rethinking the way they assess and manage risk tolerance. According to a recent Brinker Capital poll, 76% of financial advisers stated that they needed to reassess how they measure risk tolerance. The flaws of a plain vanilla approach to risk management -- relying on age-based portfolios (or other products that oversimplified the issue of risk) -- have been exposed. Have you reassessed how you measure and manage investment risk?

While the plunging stock market has been painful to investors (even with the monumental rise in the market since March, we are still SUBSTANTIALLY below the November 2007 record levels), there have been some valuable learning opportunities, particularly in regard to risk management. Historically, risk tolerance has largely been established by time horizon (how long do you have until retirement to ride out the ups and downs of the market?). The assumption was that if you had enough time, you should be more heavily invested in stock (which is sound in theory). The problem? Queasy stomachs! Many people can't handle volatile fluctuations in the market and the result is selling at inopportune times. A recent Money Magazine article (November, 2009) reported findings by FinaMetrica:
Only 7% of investors can stand to have more than 75% of their total investments in stock, and only 1% can handle more than 87% in stocks! Also, according to Vanguard, 42% of their 401(k) accounts held more than 80% of portfolio in stock investments, while it is estimated that roughly 4% of investors can tolerate a portfolio that is more than 80% in stocks.

Like any other financial information, take it with a grain of salt, but it is definitely worth some thought and some personal examination of one's investments relative to risk tolerance. Consider not only how much risk you should be taking when you invest, but how much pressure can you handle before cracking? Don't put yourself in a vulnerable situation.

Some other valid points from the Money article ...

Don't take risk unnecessarily. If you are a good saver and put away a large percentage of your income, you in turn can afford to take less risk to accommodate the same goal as someone saving less money. Just because you're comfortable with risky investments doesn't mean you need to (or should) invest in that manner.

Consider your appetite AND capacity for risk. Most of the tip has addressed one's appetite/comfort with risk. To understand capacity, again consider data supplied by Vanguard ... In 2007, 35% of 401(k) participants over the age of 55 had more than 80% of their accounts in stocks. Even if we were to assume that these individuals had the appetite for risk (didn't make emotional decisions when the market bottomed), did they really have the capacity for the risk? Could they really afford to have lost 50% or more of their nest egg at that stage of their lives?

Comfort with risk doesn't mean you'll achieve your goal. Yes, it is important to find out what your appetite for risk is and invest accordingly. You need to realize that doing so, however, can wind up putting you short of investment goals if you are risk-averse. You can save more or pare down your goals ... an answer that sounds a lot like dealing with a budgeting shortfall - you can spend less or earn more money.

Unfortunately, most (easily available - online) measures of risk are not extremely helpful. They may serve to help you think about your comfort level with risk, but will not help you make decisions regarding asset allocation or appropriately managing risk. For example, Kiplingers Magazine, a very popular Personal Finance magazine provides an online tool to assess risk. If you go to the link you'll see that there are only 6 questions - the time horizon for a 25 year old and 50 year old would be treated the exact same -- 15+ years!! Not a perfect tool by any stretch ... it is free if that is any consolation. The risk tolerance quiz provided by MSN Money provides a questionnaire that is a little more in depth. Just for fun, I googled investment risk tolerance quizzes - and of the 20 that I looked at, only 3 had more than 6 questions that were posed!

How do you assess your own risk tolerance? If you work with a financial advisor/planner, how well do they understand you and your tolerance for risk ...?