Understanding Risk Tolerance

Understanding Your Risk Tolerance

Many people change their view of risk as retirement approaches. This change is a natural occurrence as you move from your asset accumulation years, to your asset decumulation years. During the asset accumulation phase, risk is sometimes viewed as a volatile 401k balance, but during the asset decumulation years, risk might be a major adjustment to your lifestyle. It’s important to understand these changing perceptions of risk as you move toward and into retirement.

As someone planning for retirement and investing accordingly, you’ve likely heard the term “risk tolerance” before. Any time you invest in the market, you’re opening yourself up to risk. Most investors are aware of these risks, but still aren’t sure how risk should play into their financial plan. Typically, there are two ways of looking at risk when it comes to your investments:

  1. Risk tolerance.
  2. Risk capacity.

Risk capacity is how much risk an investor can take on to stay on track to reach their financial goals. Typically, investors who meet the following criteria have a higher capacity for taking on risk in their portfolio:

  • They have a high net worth. This means that even if they lost a large portion of their wealth on a high-risk-high-return investment, they wouldn’t be dramatically impacted.
  • They have less need to begin tapping their investments and therefore more time to recover. Investors who work longer, have a pension, or have a thrifty retirement budget often have more capacity for risk because they’ll have less withdrawals from their portfolio if it takes a hit when markets drop.

Risk capacity is carefully monitored over time, and it guides your advisor when they rebalance your portfolio as you near retirement.

Risk tolerance is how much risk an investor is comfortable taking on. Everyone has a different approach to risk. Some investors love the thrill of big risk investments that have the potential for a high pay-off. Other investors shy away from taking on any risk in their portfolio, and would prefer to play it safe.

The key to achieving the ideal asset allocation is to balance your risk capacity with your risk tolerance – which can be easier said than done.

What is Your Risk Tolerance?

Generally speaking, there are three levels of risk tolerance in the world of investing: aggressive, moderate, and conservative. Everyone tends to fall in one of these categories, although there is some wiggle room. To determine what category you fall into, ask yourself this question:

What would I do if the market fell by 20% in a year?

Three common answers are:

  1. I wouldn’t do anything. The market has highs and lows, things will balance back out.
  2. I would wait a short period of time, but if I continue to lose I’ll need to act.
  3. I’d sell right away. This level of loss is too much for me to cope with.

Keep in mind, there’s no right answer to this question, but it is important to put market pullbacks in perspective since they are a regular and normal part of investing. Everyone has a different tolerance level when it comes to risk. It’s important to know where you stand so that if the market does experience a low point, you have some idea of how you might react – and will be able to better regulate your emotional response.

Taking Required Risks

As much as you may want to play it safe and pad your portfolio with all low-risk investments, it’s not always in your best interest to do so. Sometimes an investor needs to take on a certain level of risk in order to achieve the return required to reach their financial goals. There are a number of decisions you can make to reduce the amount of risk you need to take on, such as delaying retirement or creating a thrifty retirement budget, but those tradeoff decisions won’t eliminate the need for higher-risk investments entirely.

Being fearful of risk, especially as you near retirement, is completely reasonable. However, if your financial goals are served by an investment strategy with more risk, you may need to put your risk aversion aside while making investment decisions.

When to Embrace Your Aversion to Risk

In some cases, you may find yourself easily powering through your natural aversion to risk. However, there are other times when listening to your gut feeling serves you. Investing is all about the long game. While most of us know this, sometimes investors let their emotion cloud their judgement. If you’re averse to risk, and the market drops, you’re more likely to make a rash decision about your investments. Pulling out of the market when things go south, or selling when your investments go through a longer period of poor performance, can hurt your long-term strategy.

Our team of financial advisors works to help people understand their own feelings about risk, and the psychology of investment management. This is partially because we believe in helping empower you to stay the course, trust your investment strategy, and prevent the market highs and lows from influencing your investing decisions.

It’s also partially because we believe in creating an investment strategy for our clients that allows them to relax and stop worrying every day about their finances. Investing is truly a balancing act, and there’s no one right answer on how to balance risk tolerance and risk capacity.

Everyone has their own worldview, and their own unique retirement goals to work toward. Risk plays a different role in everyone’s financial plan, and at Goepper Burkhardt we believe in helping you find the best way to incorporate it in your portfolio so that you can thrive both financially and emotionally.

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