What’s an acceptable level of financial risk?

By Sheryl Rowling

SAN DIEGO — Investing inherently involves risk. Even if you put everything into safe Treasury bills, you take on inflation risk. Investing in stocks, bonds, mutual funds, etc. means potentially taking on other risks such as market risk, tax risk, economic risk, single company risk, and more. When looking at how much risk to take on, you need to look for an intersection between the following:

• How much risk you are comfortable with (risk tolerance), and
• How much risk you need (to meet your accumulation goals)

Since higher returns involve higher risk and, conversely, lower risk means lower returns, the choice of portfolio risk can have substantial impact. Perhaps the biggest danger of taking on excess risk is the inclination to move to cash when the market drops. And, when the market recovers, the same investor will want to move back into the market. This is the worst possible set of actions: selling low and buying high. Thus, choosing an appropriate risk level must involve careful consideration.

When you work with an advisor, make sure your advisor does not solely rely on risk tolerance software or a questionnaire. When discussing risk tolerance with your advisor, be sure to address questions such as the following:

• Would you rather see an investment increase in value after you sell it, or see an investment decrease in value after you purchase it?
• Would you rather see your investments increase less than other investors’ portfolios in an up market, or see your investments decrease less than other investors’ portfolios in a down market?
• How much investment value decline can you accept on a weekly, monthly or annual basis before you would likely want to liquidate your portfolio and move to cash?
• Would you prefer a lower, more stable return or a higher return with more volatility?

Such soul-searching questions can assist you in gauging your risk tolerance level. And, a live discussion can lead to clearer insight than depending solely on a questionnaire.

Once your risk tolerance level is identified, your return needs must be established.  Remember, your needs may be different than your wants. In an ideal situation, the expected return set by the risk tolerance level will be adequate to meet your goals. How can you determine what your needs are? Your best bet is to get a comprehensive financial plan from a fee-only financial advisor (check out www.napfa.org  to find one).

If the expected return set by your risk tolerance limitations is not adequate, you have two options:

• Accept a higher level of risk, or
• Modify goals to accept a lower expected return

Prior to accepting a higher level of risk, ask your advisor to quantify the impacts of holding a portfolio with such a level of risk.  By quantifying potential declines in value, you can more readily identify your true ability to tolerate risk.  For example, if the higher risk level can mean a loss in value of up to 12 percent in a down year, can you handle your $1 million portfolio losing $120,000? What if there is another bad year immediately following, resulting in another loss of $105,600? If you cannot emotionally handle a higher level of risk, you must accept the need to modify your goals. This can mean lowering your monthly spending, saving more or postponing retirement.

The bottom line is that risk tolerance quantification is truly more of an art than a science. However, with the help of a good financial advisor, you can choose a portfolio that’s right for you.

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Rowling is a certified public accountant, personal finance specialist, and principal of Rowling & Associates. She may be contacted via sheryl.rowling@sdjewishworld.com