Know Your Risk Tolerance
Posted by Gail | Filed under Investing
Every investment has some level of risk associated with it. Nothing in the investment world is risk free. Understanding the different types of risk inherent in investing, and being able to come to terms with them, will take you a long way to being a smart investor.
All equity investments have some capital risk associated with them. Capital risk is the potential for losing some or all of the original money you invested. Stocks and stock-based investments like equity mutual funds can also be volatile. Volatility is the investment’s penchant for fluctuating in value over the short term. High-flying equity investments are typically associated with volatility, though you may be surprised at where volatility raises its ugly head. Industry-specific mutual funds, such as mining or technology, or funds that invest in small-capitalization companies can be very volatile. Hey, even bonds can be volatile if interest rates start to swing up and down.
Fixed-income investments such as bonds, mortgages and GICs seem relatively risk free, right? Think again. Interest-bearing investments suffer interest-rate risk. One risk is that interest rates will rise and you will be locked in to a lower rate (or that you’ll have to sell your bond at a capital loss). Another is that if you’ve invested at a high rate, interest rates may be significantly lower when it comes time to renew and your return will go into the crapper. The way around this is to ladder your investments.
Well, at least there’s your risk-free savings account. Wrong again! If your investment’s rate of return is the same as or lower than the current rate of inflation, your suffering inflation risk. The end result is that your investment will lose value year after year. Your money will be worth less.
Everyone measures risk differently since it is relative to our personal circumstances, which is one reason why you have to be brutally honest with yourself and have a big-picture perspective when you’re measuring your risk tolerance. While one person may think investing $25,000 in a small cap stock is okay, another may balk. If $25,000 represents your total savings, or if it represents a substantial part of your annual disposable income, you will be more likely to experience a sense of risk. On the other hand, if that $25,000 represents only 10% of your overall investment portfolio, capital risk is far less of a problem and volatility may not be an issue at all. So, when a financial loss would be deeply felt, the level of risk is much higher.
FIs have risk profiling questionnaires that are supposed to help you determine what your risk tolerance is so you can make better decisions as an investor. Most of these “tests” are pathetic in terms of uncovering your true feelings and measuring you risk tolerance accurately.
It’s been my experience that people with a low risk tolerance in the physical sense are also likely to have a lower risk tolerance in the financial sense. People who will jump off tall towers with large elastic bands tied to their feet seem to be those who are equally willing to leap into roller-coaster stocks. So that can be your first clue.
Just because you’re willing to throw caution to the wind doesn’t mean you should. Some people take risks because they don’t understand that they are taking risk. Or, perhaps, it is because they face extreme risk over and over that they develop a higher tolerance — almost numbness — to risk. The opposite is also true. People who are very afraid think they are taking more risk than they actually are. So daredevils may have to pull back a little to create a more balanced investment strategy while scaredy cats may have to force themselves to venture a little further out on the limb.
There are a group of psychologists who believe that regret is the correct measure against which to measure risk.
Let’s say Harry is retiring and wants to sell his house. Along comes Sue who offers Harry less than he wants but says, “Take it or leave it but tell me today.” It’s a low offer, but if Harry turns it down and can’t sell he’ll really regret it. But there’s also the possibility that tomorrow another higher offer could come and he would regret not having waited. The big question is: “Which has the least regret?”
Once you figure that out you know what path to take.
Regret doesn’t just keep us out of certain investments. It can push us into bad decisions too. Take for example the scenario many investors faced having watched stocks rise dramatically. Their realized regret at not having participated in the glory and riches of these stocks outweighed any potential regret they might experience in term of the risk to their capital so they ended up leaping into the market at a very inopportune time.
While it’s been long accepted in the area of behavioural finance that an actual loss hurts more than an opportunity loss, what if the actual loss is
- recognition – Hey, look, I’m smart,
- connectedness – and I’m part of a bunch of other smarty-pants making a killing in the market – and
- ego – didn’t I tell you that I am smart!
and the potential loss is only sweat-stained money? Then regret could work against a body.
If we allow risk to simply be an emotional issue, we are left to the vagaries of our emotional spectrum without any weight given to the role of our intellect, experience and wisdom can play in helping us better understand why we take the risks we do. The intelligent application of a sound risk profile can keep said emotional body on the straight and narrow when it comes to investing. After all, knowing who we are means we can counter the fear or reel in the greed when they start to get to better of us. We can work through the regret scenarios and lay a path while we’re still on this side of sane. We can start smart and stay smart.
Okay, it’s time to head back to your list and add in your time horizon to round out your plan.
Nexb weekt: Learn about Mutual Funds
Last week: Know Your Time Horizon
April 20, 2010 at 8:11 am
I think the Risk Questionnaires are meant to have you dive into more risky stuff anyways. I always score as someone who can take huge risks on those questionnaires, but you will never catch me jumping off a platform with an elastic band tied to my feet.
I keep the money in Mutual funds it allows me to sleep better at night and not take the risk of making bad decisions on my own.
regards,
Jason
April 20, 2010 at 8:15 am
It’s funny- I am almost completely opposite on risk. I am normally a VERY conservative investor (why put it in a bank acocunt when it can live under your mattress-type) but for about 20% of my account, I lean towards SUPER high risk investments by the bank’s standard.
I think it’s probably a matter of perspective. I live and work in developing countries most of the time, and therefore don’t necessarily think of investing abroad as a particularly risky maneuvre. Whereas RBC counts Australia and Brazil as “emerging markets”.
I figure that I’m “playing” with only 20% of my portfolio, so I can afford to absorb a major loss if it happens. I wouldn’t go any higher than that though.
April 20, 2010 at 9:15 am
I’m beginning to think that I am secrety two people.
I do not do any physical risks (jumping off a building, no thanks) — never broken a bone, give me a book over a roller coaster any day of the week…
Investing wise? High risk tolerance, although in my self-delusional moments I pretend to myself that my investments aren’t *that* risky — I’m not into diversification, I’m slightly impulsive but put alot of research in when I have the impulse.
I would like to be conservative in my investments, but feel that due to the economic climate, the fact that I am doing it all on my own — go big, or go home (to live in my sister’s basement when I’m 65).
April 20, 2010 at 9:22 am
When I did my risk assessment questionnaire, I honestly didn’t understand half of the questions on there. For a first time investor with practically no knowledge of the matter, it did make me feel like a total schmuck.
April 20, 2010 at 9:28 am
Risk is definitely a term that means different things to different people. The key thing to remember is that the investment decision that you make today should align with the short and long-term goals that you have identified for yourself.
Knowing your time horizon is all part of the financial planning process, a process that should start sooner than later.
April 20, 2010 at 9:40 am
With my training in psychometrics, all I thought of when I took the questionnaire with my financial advisor was, “Has anyone researched these things to see if they are reliable and valid?” Haven’t been able to get a straight answer on that yet-I suspect they have not. I would also suspect that our intellect wins out while answering items about hypothetical situations on a questionnaire, while our emotions win out when we’re looking at statements that show we’ve lost a pile of money in reality.
April 20, 2010 at 11:03 am
[...] Know Your Risk Tolerance « gailvazoxlade.com [...]
April 20, 2010 at 12:34 pm
The only relevant question of the questionnaire is how much you are willing to lose on your portfolio!
Not necessarily a good indicator of risk you are willing to take:
- Salary (I guess their idead is that you can make up for a loss with you salary)
- Age
- Time horizon (this is mostly an indicator of averaging out the volatility effect, not what you would do during the downturn); this is a guide on ‘generally acceptable risk on return’ over a time horizon, not an individual guide.
April 20, 2010 at 12:36 pm
LOW RISK PLEASE
I happily hop onto a dirtbike and follow my family around the trails…. wearing ALL the safety gear, and with both wheels on the ground at all times. My kids keep taunting me to GO FASTER and WHEELIE but I tell them to ride their own bikes, I’m having fun playing safe. Same goes for my investements. I have bonds, GICs and a HISA — and I have RRSPs that are diversified in the market… because I figured that’s the safest strategy. I see other people making more money at it, and I see them losing more money when things tank too. Even when buying our home we weren’t willing to risk more than we could afford to lose… we bought a house based on the qualifications of ONE income, and good thing we did too. 2 kids later, I stepped back from my career to be home with the kids (decent childcare is crazy expensive and hard to find here)… safety-girl saves the day!
Not saying high-risk is bad… like I said the rewards can be very high. It’s just not for me is all. I guess I am more a tortoise than a hare.
April 20, 2010 at 2:12 pm
I would like to be more high risk, I like the potential better return. But I know that the volatility would make me throw up, even if I did average a better rate in the long term, so I am happy where I am.
It’s very tempting to lament “Oh I should have…” but meanwhile I sleep well at night and have no regrets.
April 20, 2010 at 3:02 pm
I think financial institutions have played a large role in the ignorance of many when it comes to investing and risk. I recently went to a financial institution to connect my discount trading account with my RRSP account. The “advisor” did one of those “know-your-client-forms”. I played along (all the while feeling that my knowledge and education far outclassed hers). I found it interesting that she was still showing me graphs with “8% returns until retirement” while not offering a plan to achieve the 8% return from the mutual funds she was selling. I almost laughed out loud when she touted a fund that had a “return on 30% in the last 12 months”. She apparently didn’t notice the drop of 42% in the last three years.
When we discussed the “types of investors” she failed to mention a very basic fact of guaranteed investments – that a very conservative investor would have to save more now for retirement…much more…to compensate for the incredibly low (but guaranteed) return.
I would like to see FI’s come up with a business model for retail banking that says “hey! If we can get people to understand they’ll need more money for retirement than they thought they would, maybe we can get people to save more. And if they save more of it with us –we’ll have a stronger bank!” None of this “you’re richer than you think” crap. Just my opinion stemming with frustration over the things banks can’t be bothered to explain to their clients….
April 21, 2010 at 2:05 am
[...] This post was mentioned on Twitter by 2 Cents. 2 Cents said: Know Your Risk Tolerance – http://b2l.me/qa2d3 From Gail Vaz-Oxlade [...]
April 21, 2010 at 6:47 am
I have to send a big shout out to Geoff! Because of him I have been researching MERs and other fees that are tacked onto mutual funds and I have come to the realization the my FA is the only one profiting from my investments… Not such a safe investment after all, talk about risk!
I discovered that despite my investments dropping by almost half their value, my FA still walked away with a healthy profit. Not as much as he would have made if the market hadn’t tanked, mind you, but still not bad for saying he doesn’t do much for me except once a year…
So, IMHO, mutual funds are not only high risk, but a just plain bad investment overall and I have decided to take matters into my own hands. Of course I’m kinda stymied because of the back-end-fees (thanks again FA) so can only withdraw portions of my mutual funds without being hit with hefty (sometimes 5%) fees, but in the end I will be my own FA.
Thanks again Geoff, your words finally sunk in and I did my own research and guess what? You were right!
To everyone else… Heed Geoff’s words and do a little research. Mutual funds are only low risk for the salespeople (oops, I mean Financial Advisors) while our investments can’t even come close to making the high returns they want you to think they do.
April 21, 2010 at 9:07 am
@ SimpleSavings – thanks for the shoutout ;0 but I have a few little observations that will hopefully reassure you.
1. First, everything I’ve learned about mutual funds is from blogs like this one, and canadiancapitalist .com
2. Not all mutual funds are inherently bad. What’s bad are FA’s who say they’re ‘no fee’. That’s not true and really cheeses me off.
3. Not all mutual funds have a high MER. – And keep in mind I’m not against a high MER, but like anything only if the results justify the cost, which in most cases they don’t.
4. Consider the TD e-series index funds; they have a very low MER (like .5%) and are index funds so relatively safe (as they compromise stocks of the largest companies). You won’t hit a home run but you won’t strike out either (ymmv). Depending on your age /risk tolerences a typical portfolio might be 25% us index, 25% cdn index, 20% international index and 30% bond index. Easy to rebalance as needed.
5. Do the math and consider if it’s worth it to pay the DSC (back end) fee or not. It may be worth it just to be free.
6. Good for you for asking the tough questions that so few people in Canada do. In the US, it seems people are more hardcore.
May 20, 2010 at 11:05 am
Geoff has made some good points but let me add a few.
Years ago buying an index (Nortel represented at one time 30% of the TSX) helped you when the market went up but did not on the way down. The financial stocks are priced to be in much better shape today than in 2007. Since financial and other stocks are priced high today, based on earnings, if the market goes down (which it is) the index(stock) does not help. This applies to many mutual funds which follows the market as well.
The risk questionnaire is to help the client/advisor/bank/dealer. What I think here is many clients do not understand risk. As I pointed out earlier, you can have many years (as seen the last 10 years) of poor returns. Many people think that higher risk means higher returns…which may not happen.
Since many countries in Europe have defaulted in the past does not mean it can not happen again. California (which is the largest US state) has a debt rating the same share a Baa1 ranking, three steps above non-investment grade, from Moody’s Investors Service this is the same credit risk as Kazakhstan. Debt levels are at an all time high which may take many years to pay down.
September 10, 2010 at 11:11 am
[...] What type of Investor are you? Are you shopping for a company where you can get involved at an earlier stage that promises to grow faster and produce a greater profit than other companies? Or do you prefer to follow the momentum of other investors and get on board with a fund once you see others also getting on board? What type of strategy are you more comfortable with? It’s important to look at the type of person you are and what level of risk you are comfortable with. But be careful, often Financial Advisors, and other Banking institutions will give you a “risk tolerance” assessment in order to determine an investment strategy for you. These assessments can be confusing and may not produce accurate results. For more information, read this blog on Risk Tolerance. [...]
October 7, 2011 at 5:10 pm
[...] and your responses, you'll be able to determine successfully your risk tolerance for investing.When you're ready to invest, you are likely to consider the amount you have available to invest and …to lose or gain. For your own continued sanity, it's wise to determine your level of risk [...]