If you are talking with an investment representative, a stockbroker or a financial advisor, you most likely will talk about “risk tolerance.” Risk tolerance is a term used in the investment business to talk about the willingness of a client to accept a loss in the value of their investment account over a short period of time.
Many times, an investment sales person is required to have a risk tolerance document on file for every client. This is a liability management strategy by the parent firm to protect them from future complaints by the client. In this case, the risk tolerance instrument is more about protecting the investment sales person than it is about helping the client more effectively reach their financial goals.
Risk tolerance factors
For families who are more interested in reaching goals than buying a great investment product, there is a better approach to the risk tolerance process. And, of course, there’s a bit more to it than filling out a 10-question form.
The technical idea behind a truly useful understanding of your risk tolerance combines two factors:
- Just how much does it bother you to see your account value fall? This is the information most risk tolerance forms are pretty good at collecting. Follow this link to learn your Risk Number. You will experience a typical risk tolerance quiz.
- Just how much change in value can you actually tolerate from a financial standpoint? The answer to this involves more detail and is best done within the context of a holistic financial plan that looks at all aspects of your financial life.
How to measure risk tolerance
When my clients ask me to be their investment manager, here is the way I handle risk tolerance.
- As a fiduciary financial planner, I’m my client’s advocate at all times. So my motivation is to serve my client’s best interest at all times.
- I’m paid by my client on a fee-only basis, so I have no financial incentive regarding any products. It’s in my financial interest to keep investment costs low and avoid unnecessary risk.
- I manage investments on a discretionary basis, which means I’m charged to take any prudent action I deem necessary in a prompt and efficient manner. This means I can, and I will, make any adjustments I think will help you meet your goals as soon as I see the need.
- As I talk with a new client about investment management, we always complete an investment policy statement that defines the guidelines for me. We discuss the purpose of the money. If it’s needed to pay a tax bill in six months, that’s very different from money that’s intended to be a legacy for the grandkids in 30 years.
- I work with clients to understand their spending needs. If they need to use a portion of the investment money, we define when and how much they will need. I then use time-based buckets to separate the money.
- Money needed for spending in the next 12 months will be in cash and money market accounts. This money is safe, liquid and easy to access when needed.
- Money needed after 12 months but before 36 months is in fixed date bond funds. These investments have an expiration date when they cash out. I match the maturity dates to the date when we expect to need the money. This money is a bit less liquid, earns more interest and can be cashed out whenever it’s needed.
- Money needed after 36 months and before 60 months is typically invested in a balanced fashion. These investments target a 50-percent-stock-to-50-percent-bond mix. This money will typically grow a bit faster than inflation and should hold its value in up markets and in down markets.
- Money needed after 60 months is typically invested in a balanced mix of stocks from across the world. I usually like to use as many as eight asset classes for best results. This money can fall in value over the short term but with 60 months to recover it outperforms the other buckets. Based on current economic conditions, my experts project an all-stock account to return about 6.9 percent annual average growth over the next five years.
- We always monitor the investments the client owns, the general economic situation and the client’s goals to be sure we know when the investment plan needs to be adjusted. On-going monitoring and making adjustment when needed help smooth out market swings.
Help understanding your risk tolerance
You may feel like this is all a bit complicated, and it is. But I think it’s less complex and easier to understand if the client works with a well-trained, trusted professional. I suggest you consider getting the help of a CERTIFIED FINANCIAL PLANNER™ professional.
To find a CFP® professional near you, start your search here.
As you visit with financial planners, I suggest a couple things to check:
- Is the advisor always the client’s advocate – a fiduciary advisor?
- Is the advisor only paid by clients, not any financial product manufacturer or distribution network? That would be a fee-only advisor.
These two points help assure that you are working with a professional who is committed toyour best interest at all times. It seems sort of obvious to me that a professional would work in this way, but it’s not automatic.
A fiduciary, fee-only, CFP® professional can help you make great choices about your investment risk. Together you can develop a holistic financial plan that is driven by your goals and priorities and addresses all aspects of your financial life. With a big-picture approach, you will be better prepared to understand your options at every step along the way.
Yes, I am a CFP® professional. I’m always a fiduciary and I only work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
If this article has you thinking about your own circumstances, contact my office atrdunn@dunncreekadvisors.com. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.