Last time, we discussed investor behavior and the actions that can negatively impact a financial plan (click here if you missed it). This week, to continue our discussion, we will look at some of the tools and concepts that can be used to manage investor behaviors.
Risk tolerance is the amount of volatility an investor is willing to accept in their investments. One’s risk tolerance is identified by answering a series of questions to understand a person’s willingness to take on risk and their comfortability in various market scenarios. The answers to a risk tolerance questionnaire will tell you if you’re conservative, moderate, aggressive, or somewhere in between. From this knowledge, an asset allocation model can be created that is suitable to one’s risk. As we consider market volatility and the emotional urge to act when things are going good or bad, one of the tools to re-visit to make an objective decision is the already identified risk tolerance of the investor.
Understand that risk tolerance is something that may change over one’s lifetime for various reasons. This is why it is important to confirm risk tolerance periodically.
Risk capacity, though it seems like it would be the same as risk tolerance, is quite different and another one of the main tools used to remove emotions out of investment decisions. Risk capacity is how much risk one can afford to take. There are a few things to take into consideration when considering one’s risk capacity, but the main two are your age and your income potential. For example, a 30 year old doctor will have a higher risk capacity than a 60 year old machinist. The doctor has more time on her side to weather a market downturn, and she has a higher income potential with the ability to save more money if needed, and thus can afford to take on more risk than the 60 year old machinist.
Time horizon is the amount of time one expects to hold an investment before they will need the money. Time horizon is part of risk capacity, but it’s important to look at it separately, especially when it comes to removing emotions from investment decisions. The 30 year old doctor should be less concerned, or even not concerned at all, about what the markets are currently doing. Her focus should be on saving for her goals and for retirement (based on her risk tolerance) which is decades away. Whereas the 60 year old machinist should be a little more concerned about what’s happening in the markets, as he doesn’t have a lot of time to ride out a market downturn and wait for a recovery. However, assuming the machinist understands his tolerance and capacity for risk, and has invested accordingly, then he should be comfortable sticking with his already established plan.
All of these factors have a part in helping to put together and manage a successful retirement income plan based on one’s specific needs and lifestyle. If you need help, email me at Christopher.Hull@CeteraInvestors.com or call me at 716-707-1818.
Next Time: Finding the Right Advisor For You
The views stated in this letter are not necessarily the opinion of Cetera Investors and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.