Q: My financial adviser was discussing my “risk tolerance” at our recent meeting. What was she talking about?
A: Risk tolerance is a factor that many investment advisors and financial planners try to ascertain when making portfolio decisions such as an asset allocation for their clients. It is supposed to be a rough measure of how well (or not well) an investor family will respond to prices moving up and down in the portfolio (volatility) over short to intermediate periods of time. An investor with a low risk tolerance is thought to be one that favors portfolio stability and should therefore accept a likely lower long-term return. Someone with a high-risk tolerance is thought to be fine with much more volatility in the prices in their portfolio.
As a good thought experiment on your “risk tolerance," imagine the following scenario.
I will offer you a coin toss that will either pay nothing or $1 million. But I will also offer you a guaranteed amount of money to avoid the coin toss. I’ll start out with a guaranteed $100,000, and if you will not take that, I’ll increase the amount by another $100,000 up to $400,000. Those who take the $100,000 have a low risk tolerance, as the value of the coin toss is half of $1 million (albeit with the risk of getting nothing). Those who want more than $100,000 have an increasing amount of risk tolerance up to the maximum risk tolerance of just taking the coin toss. What would you do?
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There are different other ways of trying to determine risk tolerance. There are many professional programs that can be used as well as some simple questions. I often ask families I work with about their reaction to market prices dropping as in 2008 and 2020. If I’m told they were “sick” over the drop in prices, I will assume they do not handle risk well. If they tell me they ignored market movements during those times (and in general), I’ll assign them a higher risk tolerance mentally.
But even having said all this, I find that the concept of risk tolerance difficult. When other variables unrelated to market prices exist, one’s “risk tolerance” can change a lot. Imagine an individual who lost their job and has had difficulty finding work. They will usually be much less tolerable of downward prices in their investments until their work life is steadier. And market moves themselves often change measures of risk tolerance. In significant bear markets with lower portfolio prices, we see that many people develop some fear and a marked drop in risk tolerance. In frantic bull markets, we see the opposite, with people willing to take much more risk than in the past.