What Do Your Mattress and a Roulette Table Have in Common? (HINT: more than you think.)Feb 28, 2020
With this blog post I’d like to share some thoughts about investment risk tolerance.
Generally, we think about risk as a bad thing – something we want to avoid. “I won’t drive faster and risk a speeding ticket”, and, “No, baby, that dress doesn’t make you look fat,” are two examples of conscious choices made to avoid unpleasant consequences.
The context for risk in this post is investment risk – I put money out there in some type of vehicle, and expect it to be returned to me, and then some. And then some can be interest, dividends, capital gains, and lottery winnings.
The risk return spectrum looks something like this:
- If I keep money under the mattress, what is my expected return? Zero. It is not invested.
- If I want safety, and put my money in the bank, what is my risk? Next to nothing. But the return is also minuscule these days.
- I can make a little more money in bonds with some risk to my invested principal – largely interest rate risk.
- Continuing out the spectrum, I can invest in equities – common stock, either outright or in mutual funds and ETFs. Now I expose myself to market risk. Over many years the S&P 500 Index has returned a little more than 9%. But to get that return, I have to invest for the long term, as the stock market is volatile.
- Moving up the risk/return scale, I can purchase options on those stocks, and potentially magnify the return even more – both on the upside and the downside.
- Still too conservative for you? You can invest in futures contracts.
- And you can invest in options on those futures contracts.
- And finally, there's always gambling: roulette tables and lottery tickets.
How does an investor decide where on this scale to invest?
This is matter of comfort and expectations. Somewhere on this chart the investor has to decide where saving stops and investment begins, and then where investment stops and speculation begins, and then where speculation stops and entertainment begins. Clearly the risk return relationship is simply one of degree, and each investor has to place himself somewhere on the line – money in the mattress all the way to the left, and putting it all on red to the right.
Next, time horizon. How soon do I need these funds? If I’m saving for a down payment on the home I hope to purchase in two years, the time horizon is short and I should take minimal if any risk. A bank account works. Not much earned these days, but at least nothing will be lost.
If I am 40 and will work till 67, then maybe I’m willing to take on more investment risk, knowing that markets move up and down, but the long term trend is upward.
Tortoise or Hare?
After time horizon, are you the tortoise or the hare? How much variability can I stand on the way to my goal? In other words, if I have $1000 to invest, and I know that over time the investment will grow 10%, can I stand it if it drops to $900 at some point along the way? How about to $800 – or even lower?
Answering these questions is a crucial part of the work we do with people. There are lots of investment risk tolerance measures out there – questionnaires with embedded algorithms which, after I answer a few questions, tell me whether I’m moderate, moderately aggressive, or an aggressive investor. How useful those labels are for an individual investor is unclear.
To that end we have introduced Riskalyze into our practice. It is one of the more awesome pieces of software we’ve encountered. It is intuitive, and easy to use.
The steps are these:
- The client completes the questionnaire. The result is a risk score.
- Analyze the client’s current portfolio. Plug in the client’s current holdings to generate a second risk score for the portfolio. The two risk numbers will often differ. As a result a good discussion should happen – what do we adjust? Your perception of investment risk, or the securities in your portfolio?
- Project out the likelihood of reaching one’s retirement goals. Riskalyze will take the score of your current portfolio, your current age and projected age at retirement, rate of savings, and income required and calculate the percent chance of you reaching your goal.
Sound interesting? Give it a try! See how Riskalyze scores you. If there’s a discrepancy between what is and what should be, make an appointment on our website to come talk it over with us.
Get in touch!
Check out Jonathan's piece on Goals Based Investing. We've also done a piece on Investment FAQs. Questions? Feel free to get in touch with us at [email protected] Also follow us LinkedIn, Facebook, Instagram, and YouTube for more personal financial information relevant to you!
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