When it comes to investing, everyone’s comfort level is different – and for different reasons. Losing sleep at night because you are invested in a way that is too volatile may be a sign that you are invested too aggressively. When an investment fails to keep up with the current rate of inflation may indicate that you are invested too conservatively. There are many types of risk and risk tolerance is hard to define.
When determining an asset allocation for a client, risk tolerance is one of the most important factors to consider. At Windward, we view risk tolerance as a combination of two concepts: risk tolerance
- a client’s capacity for risk and,
- a client’s comfort with risk
Both of these factors are considered when assessing client risk tolerance. A client’s capacity for risk focuses on the client’s objective, factual circumstances. Things like the client’s investment time horizon, liquidity need(s), who and how many people are dependent on the money, debt/credit level, income and insurance coverage, and similar items are considered. These situational issues all factor in to portfolio construction. After the client’s capacity for risk is assessed, the client’s comfort for risk becomes the point of focus.
A client’s comfort for risk is more subjective and has to do with the client’s personal investment experience and history, their understanding of the trade-off between risk and return, their ability to tolerate occasional negative returns and what level of involvement the client wants with monitoring and making decisions about their investments. A client may have an enormous financial capacity for risk, but understanding the client’s comfort with taking investment risk is crucial.
Once the client’s risk tolerance is understood, constructing an asset allocation based on this information is the next step. When it comes to risk-averse clients, their portfolios may hold a higher percentage of stable investments like government bonds and money market funds whereas a risk tolerant client may hold a higher percentage of “volatile assets” such as small growth or international stocks or funds. Finding an appropriate balance of “stable” and “volatile” assets determines the portfolio’s risk. This balance is determined using a portfolio optimization model that tries to optimize returns for a given risk level.
Overall, education about the types of risk and understanding your personal risk tolerance is a defining factor in putting together an asset allocation. Risk tolerance can be a broad concept, but Windward focuses on client’s capacity and comfort for risk. Being too conservative or too aggressive can both be impediments to achieving your financial goals. Finding the “Goldilocks-Just Right” portfolio that matches your risk tolerance is difficult but important. If you have questions about your risk tolerance or are interested in setting up a Mutual Discovery Meeting, Contact Us!
This blog is provided by Windward Private Wealth Management Inc. (“Windward” or the “Firm”) for informational purposes only. Investing involves the risk of loss and investors should be prepared to bear potential losses. No portion of this blog is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in the individual blog posts will be derived from sources that Windward believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages.
Windward is an SEC registered investment adviser. The Firm may only provide services in those states in which it is notice filed or qualifies for a corresponding exemption from such requirements. For information about Windward’ registration status and business operations, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the SEC’s Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov.