Investment risk comes in almost as many guises as Lady Gaga. Most of us are familiar (oh, how familiar!) with “market risk”: the risk that an investment’s value will decrease due to market factors. “Inflation risk” is the danger that rising prices will diminish the buying power of a dollar. Then there’s “credit risk“: the once-unthinkable possibility that General Motors would go bankrupt, or that homeowners would massively default on mortgages backing up bonds we taxpayers insured. And so on.
Strictly speaking, risk refers to the chance that an investment’s actual return may be different than expected, and includes the possibility of losing some or all of your original investment. Knowing that, how can you assess your own risk tolerance?
Investment professionals use a variety of risk questionnaires, with mixed success. The problem is that questions about one’s capacity for risk (i.e., financial situation) are often tossed in with questions about attitude toward risk (willingness to accept the accompanying uncertainty and anxiety). In a recent Investment Advisor article, Michael Kitces, CFP, CLU, and director of research for Pinnacle Advisory Group, suggests a third factor: perception of risk, which can change from week to week and headline to headline.
When an investor’s answers involving all these variables are averaged, the “risk score” that emerges may well be useless. For example, a 50ish worker without much savings may be wary of risky investments, even though his only hope of reaching his goals is to take on more risk. What’s his risk tolerance? Conversely, someone who has built up a sizable nest egg through aggressive investing may enter retirement still fixated on investing aggressively – although the associated risk could actually destroy her financial security. Is her risk tolerance high or low?
Kitces recommends addressing the different faces of risk on three fronts:
1. Education to correct faulty perceptions. A red flag should pop up when an investor starts to imagine, “This time it’s different.” In 1999, people thought risky tech stocks had suddenly become safe. In 2005, it was widely assumed that home values would continue increasing by 8% to 20% a year. Investors can often benefit from more research (or cautionary words from an advisor) to adjust their own risk perceptions before they leap.
2. An objective look at risk capacity. This is familiar personal-finance territory, involving length of time to retirement, availability of guaranteed income, ability to self-insure for long-term care, and so on. Advisors can add Monte Carlo projections to estimate portfolio performance.
3. A separate assessment of risk attitude. This is what makes one investor fundamentally uncomfortable with high-risk derivatives, and drives another to distraction at the thought of super-safe investments and allocations.
It may seem that the worst possible risk is failing to reach your goal. But as Kitces and others advise, don’t react by creating a portfolio that crosses the line into causing intolerable fear and anxiety. Your aim is to take intelligent risk – and by carefully considering its different faces, you’re more likely to manage it well.
