Before you invest one dollar with an investment advisor, they will have you fill out some form of risk assessment questionnaire. These may be called by different names, but they all aim to do the same thing, to find out how comfortable you are with losing money. While that may sound strange, the fundamental way to success with your investments is to not lose money. However, success and wealth are two different things. Which is why when it comes to risk tolerance, one classification may not fit all investors at all times.
Why conservative investors want to go back to the future
The 1980s gave us many things like big hair, argyle sweaters, and movies like “Back to the Future”. It was also a golden age for investors who liked high-interest rates on their certificates of deposit (CDs). With rates for a 5-year CD above 10% as late as the mid-80s*, they were a good option for the low-risk investor. If you were saving for a child’s education, the down payment on a house, or even your retirement – you could have done worse than a 12% return on your money. Even as late as 1999, investors could earn about 5% on a 5-year CD. Today, it’s a different story. With the Federal Reserve dropping interest rates to historically low levels and keeping them there, today’s investors would be thrilled to find a CD with a 2% interest rate.
Times have changed. If a conservative investor follows the low-risk tolerance playbook, their portfolio would include nothing more than savings accounts, CDs and money market funds. This is the trap that can lead many investors to be too conservative in their investments at too young of an age. While it’s true that retirement-age investors must make capital preservation their primary goal, even the most cautious younger investors are realizing that they need some exposure to equities in order to realistically meet their investment objectives, even if they nearing retirement. Fortunately for these investors, there are a variety of options including index funds which, while still capable of losing money, are more predictable than aggressive funds because their stated objective is to match the performance of a particular index (e.g. the S&P 500).
When aggressive investors should tap the brakes
On the other end of the spectrum, an investor in their late 20s may claim to have a high-risk tolerance. But what they’re really saying is that they have a high-risk tolerance when it comes to their retirement savings. They are expecting to have 30 or more years to put money away. If their goal is for the highest total return they can get, then they are confident that a portfolio of growth stocks should be able to weather the ups and downs of even the most volatile market.
But what about the money they are setting aside for their first house, or their newborn child’s education? Now the time horizon (i.e. when they will need the money) is shorter. The same strategy – and investments – that may work well for their retirement portfolio may be inappropriate for these goals. In the case of a college fund, they still are striving for a high total return, but they may prudently be looking for safe havens to shelter profits so that the money, once earned, will still be there when they need it.
Risk tolerance is not the same as risk capacity
The example above illustrates the concept of risk capacity. An investor might not react emotionally to the idea of losing money, however, a shortened timeline gives them less margin for error. They cannot afford to take on that risk. This can also be true of an otherwise aggressive investor who is now approaching retirement. As much as they may want to keep the pedal to the metal with regards to their investment, their capacity for risk is much less and prudence will dictate some lower-risk strategies.
What do investing and fantasy sports have in common?
Fantasy sports have fundamentally changed the way sports fans take in their favorite sports. Today, many fantasy football “fans” will spend an hour or more doing research to set their lineup for one team. And when you consider they may be on several fantasy teams, they are devoting literally hours per week to setting their lineups.
But even with access to statistics that didn’t exist a generation ago, the fantasy football player won’t know how well they picked their lineup until the games are played. Information is power, but no decision is without risk.
It’s the same with investing. Risk tolerance is psychological, and some investors simply cannot stomach the idea of losing money in the market. Yet, even the most aggressive investor cannot know for certain that a certain trade will work out the way they want. The antidote for this fear is information. The reality of our data-driven economy is that, like making a decision about your fantasy team, investors have the ability to have much more information regarding the past and likely future performance of a given investment. At the end of the day, that’s all you can hope for as an investor, the opportunity to make an informed decision that allows you to sleep at night.