At some point in your investment life you’ve probably been asked to determine your risk tolerance. This is necessary to create the right portfolio for your investment profile. You may have even completed a questionnaire that helped you find out where you stand. But is there a time when you should reassess your risk tolerance?
What is Risk Tolerance and Why is it Important?
Investing involves a trade-off between risk and reward. Generally speaking, investments that produce higher returns also involve higher risk of loss. Risk tolerance is essentially how much risk you’re willing to accept in exchange for a certain return on your investments.
Risk tolerance comes in three general categories, though there are different variations between each:
If you fall into this category, the idea of losing money on your investments makes you uncomfortable. You prefer safer investments, the kind that won’t cause you to lose money. At the extreme, you might even be completely risk averse, which would limit your investment opportunities to safe, interest-bearing investments that don’t fluctuate in value.
You’re willing to accept a modest degree of risk in exchange for higher returns. You might be comfortable with a portfolio that has a slight majority in stocks, but a large minority in safer assets.
You have little fear of losing money, and you’re willing to risk the majority of your portfolio in stocks and other equity investments that have the potential to generate greater returns than safe assets.
Understanding your risk tolerance is important in determining the asset allocation in your portfolio. For example, if you’re conservative, you might have 80% of your money in safe assets, and 20% in stocks. Moderate may be 60% stocks, 40% safe assets, while aggressive might be 80% or 90% in stocks, and only 10% to 20% in safe assets.
How Risk Tolerance is Determined
Many, maybe most, investment platforms today offer some form of risk tolerance assessment. This is often a series of questions designed to measure your ability to accept risk. The questions will center on your investment goals, investment time horizon, and how much loss you’re prepared to risk in pursuit of certain levels of return.
However, the US Securities and Exchange Commission (SEC) warns that while such questionnaires may be a useful starting point, the results may be biased toward financial products or services sold by the companies or individuals sponsoring the websites.
What’s also important to understand is that risk tolerance is not a fixed determination. At different times in your life your risk tolerance may change.
What are some of the circumstances where that might happen?
When Should You Reassess Your Risk Tolerance?
While it may be tempting to assume a constant risk tolerance, the reality is that it changes as your life changes.
Here are a few examples:
As You Get Older
Risk tolerance generally declines with age. This has to do with greater life experiences and awareness, as well as a reduction in your investment time horizon.
When you’re young, you may be an aggressive investor. That makes sense, because you have decades to make up for any losses that may be caused by a stock market crash or prolonged bear market. But as you get older, there’s less time to overcome significant losses.
If you’ve experienced a number of major ups and downs in the financial markets, that may also make you more conservative. Aware of the potential for loss, you may find yourself increasingly unwilling to expose your portfolio to the potential.
As You Get Closer to Your Investment Goal(s)
If an investment goal, like retirement, is 30 years into the future, it’s easier to be aggressive. You have plenty of time to ride out the ups and downs of the market. Just as important, you’re in a better position to take chances because you have no immediate need for the money.
But as you get closer to your investment goal, in this case retirement, you have a need for a certain portfolio level. If you’re close to that level, and to your goal, you’ll necessarily become more conservative. There is no need to take unnecessary chances when the investment goal is within sight.
When Your Family Situation Changes
The perfect example here is the birth of a child. As a single person, or married with no children, your risk tolerance level may be very aggressive. You might even have 100% of your money in stocks. But with the responsibility of raising one or more children, you might become more conservative. That’s because the prospect of taking a significant loss in your investment portfolio will affect your family, and not just you alone.
Conversely, your risk tolerance might increase when your children come of age, and you’re no longer primarily responsible for their support.
When Your Occupation or Income Changes
If you have a particularly secure job, with a comfortable income level, it’s easier to be aggressive with your investment activities. But let’s say you go from a salaried position to one that pays primarily commission income. Since there is now greater risk associated with your income, you may decide to become more conservative with your investments.
The same situation could happen if you were to take a major pay cut on a salaried job. Due to the constraints of the tighter household budget, you might become more conservative with your portfolio, just in case the money becomes necessary to support your budget.
If You Experience a Significant Health Event
If you enjoy good health, it’s easier to be aggressive with your investments. But should your health decline, you might become more conservative.
The reason is simple; if you’re healthy, you probably have no immediate need for the funds in your portfolio. But if your health deteriorates, the need to tap your investments might become a real possibility. That being the case, you might shift to a more conservative portfolio.
Similarly, should a health condition significantly improve, you might shift back to a more aggressive portfolio.
If You Experience a Major Life Change
Divorce is an example. If you’re in a stable marriage, you can be more aggressive with your investments. But if your marriage ends in divorce, finances may be stretched, opening the possibility that investment funds may be necessary for basic living expenses.
As well, the shift from a two income household to a single income household usually requires a more conservative investment approach.
By contrast, if you’re single you may be fairly conservative with investing. But if you get married, you might become more aggressive on the strength of two incomes.
Final Thoughts on Should You Reassess Your Risk Tolerance
As you can see, your risk tolerance isn’t a fixed situation. It will change as your life changes, and you need to adjust accordingly. If it’s been a long while since you reassessed your risk tolerance, it’s probably time to take another look at it now. And you should revisit the idea any time you experience a significant change in your life along with re-evaluating your investment portfolio.