How Risk Tolerant Are You?
When you received your first quarter investment statement, how did you react? Were you still comfortable with your portfolio’s asset mix or did you want to change your strategy and lower your exposure to stocks?
Investor reactions to performance is tied to their risk tolerance. The amount of risk you are willing to take will affect your portfolio’s construction and the rate of return you can expect long term. Your risk tolerance is one aspect that is considered to establish an investment strategy that is suitable for you.To that end, your financial advisor will ask you a series of questionssuch as how you would react if the value of your portfolio dropped by 20% to 25% over a short period of time, or what type of investment your would prefer, with options varying between an investment that can generate a higher return with the possibility of a bigger loss and one with a lower return but with a smaller potential loss. While these questions give good talking points to discuss market volatility and its impact on investment returns, it is quite difficult to evaluate one’s risk tolerance.The main reason for this is that the questions are somewhat hypothetical.It is difficult for people to accurately predict how they will react in each situation until they experience it.Investors can’t know exactly how they will react to double-digit negative returns until they see it. People are more risk tolerant when investment returns are positive. After all, there is nothing scary about rising markets. However, during a correction or a bear market such as we have seen in the first quarter, suddenly, the risk tolerance questions are no longer hypothetical, they become all too real. You now know how you react to a drop in your portfolio’s value. To achieve those potentially higher returns in the long-term, you now know what type of short-term setbacks you may absorb. If you have experienced market downturns before, such as in2001-02 or 2008-09, your memory of how you felt then naturally is hazyat best because of the strong market returns of the last decade, giving you the impression that those downturns weren’t that bad, even though they were. The best time to evaluate your investment risk tolerance is immediately after you have experienced the pain of negative returns, because you now have a much better idea how you react to turbulence on the markets. You are not speculating on how you will feel, you know how you feel. If your risk tolerance is different now than it was before, should you change your asset mix? This depends, since risk tolerance is only one element when establishing your investment strategy. But there are other factors to consider, such as your time horizon, overall financial situation and your investment objectives. While making changes to your asset mix may address your risk aversion as it relates to markets, it is important to understand the impact those same changes will have on achieving your goals. If we assume that generally, over many years, a more prudent investment strategy will generate a lower average annual return, will your goals still be attainable? How comfortable are you with the risk of not achieving your investment objectives? Before making significant changes to your asset mix, it is important to look at the big picture. Having a financial plan in place will help you make an informed decision.
This writing is for general information purposes only and is not intended to provide legal, accounting, tax or personalized financial advice. For complex matters you should always seek help from a professional. Any opinions expressed are my own and may not reflect those of Louisbourg Investments. Author:
Marc André Castonguay, CFP®, CIM® is financial planning manager at Louisbourg Investments. Comments or questions may be submitted to him at email@example.com.