Understand the Potential Rates of Return and Volatility for your Risk Tolerance
If you have ever researched investing, you have probably come across the concept of risk tolerance. In fact, you may even have taken some version of a risk survey. The concept usually revolves around how much risk or volatility you are willing to accept while investing. The risk tolerance level you choose can have a considerable long term effect on potential rates of returns and volatility. Before you make your decision about your level of risk tolerance, you may want to understand some of the basics.
All investments are considered to have some degree of risk and are often categorized into Aggressive, Moderate, or Conservative Categories. Aggressive investments tend to have the greatest potential for higher investment returns in exchange for higher volatility, and Conservative investment behave in an opposite fashion. In general, a classic example of a Moderate investment is a 60/40 stock bond split.
But these categories do not give you specific details, such as what rate of return an Aggressive investment could hit or the volatility for a Conservative investment. Also, even within an individual category, you can have investments that behave wildly differently under different market conditions.
Does Your Risk Tolerance Level Actually Match Your Goals?
As one ages and approaches retirement, many sources will suggest you need to diversify and take less risk. As an example, if you invest in a target date fund with a 2030 retirement date, that fund will attempt to de-risk during the years approaching 2030 and during your retirement. By choosing this less risky option, you give up potential for a greater rate of return. You have to ask yourself if that is worth it in your case?
Adjust your Goals or Risk Tolerance so They are In Line with Each Other
One of the first problems you may run into when determining your risk tolerance level is the trade-off between the rates of return and volatility. Consider two hypothetical investments, both earning 5%. One is modeling potentially to go down 10% and the other potentially to go down 20%.
This could be material information you need to make a decision. That information is hard to find, though, as risk tolerance and risk tolerance surveys don’t often show this. One of the challenges even for advisors is how to translate concepts such as Moderate Risk Tolerance Level into math.
The second problem you often run into is that long-term investment returns could matter more than your volatility. Let’s say a hypothetical investment might earn 7% with a potential loss of 20%, and another investment might earn 4% with a potential loss of 10%. In both examples, you might lose money.
Of course, if given the choice, you would prefer to only take the 10% loss, but what if the other side of this equation suggests over 10 years you might have 30% better returns choosing the option with the potential 20% loss? Does it matter in your situation in the short term if you could lose 20% or 10%, or is it better in your situation to go for the higher potential returns?
The third problem is that your risk tolerance decision should often be based on your overall financial situation and goals. Consider two different people, one has a pension and Social Security covering their known expenses; the other has Social Security and needs significant withdrawals from their investments. Each of these people can choose whatever risk tolerance they want, but often the person with the strong fixed income can take significantly more market risk. This could potentially lead to materially larger returns.
Looking at your goals adds another wrinkle– what if the math suggests you need to hit a 6% potential rate of return to meet your goal? Did you choose a risk tolerance that meets that number? Do you need to re-assess your goals or risk tolerance?
We usually suggest when building out your investment portfolio that we peer beneath a risk tolerance survey or risk score and examine potential rates of return and volatility. After all you would not set sail on the ocean without having at least a basic knowledge of how to get to your destination. So why would you invest based on your risk tolerance without making sure your risk tolerance will meet your goals?
Jon R Erickson CFP®, CEBS®
Investment Advisory Services offered through Regal Investment Advisors, LLC, an SEC registered investment adviser. Fortress Mega, LLC is independent of Regal investment Advisors. Registrations with the SEC does not imply any level of skill or training.
The information contained in this presentation neither constitutes an offer, nor the solicitation of an, offer, to invest in any particular fund or investment product. Past performance does not guarantee future results. Investments inherently carry risk including the loss of principal which the client should be prepared to bear.
Neither Fortress Mega nor Regal Investment Advisors, LLC are a law firm or an accounting firm and no portion of this should be interpreted as legal, accounting, or tax advice. Information expressed does not take into account your specific situation or objectives and is not intended as a recommendation appropriate for any individual. Participants are encouraged to seek advice from a qualified tax or legal professional to determine if any information presented may be suitable for their specific situation.
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