Risk Tolerance vs Asset Allocation: Finding the Right Balance

When people hear the word risk, they usually visualize “dangerous” things like riding a motorcycle, starting a business, or maybe even a high-stakes game of poker. Taking on risk often comes with the potential for reward – in poker, you can never win a big hand if you don’t ante up. In investing, there is also a correlation between risk and reward, and no investment is entirely without risk. Risk is potentially the single most important factor to consider when determining the ratio of stocks and bonds in your portfolio; this ratio is the biggest determinant of investment performance over time. Risk, however, is not one-dimensional.

The 3 Components of Risk

There are three components to every investor risk profile: risk tolerance, ability to bear risk, and how much risk an investor needs to take on to achieve their goals. These components are distinct but interrelated and guide how to construct the portfolio from an asset allocation perspective.

Risk Tolerance

The first component, risk tolerance, is how an investor feels about risk. If you were to ask a young, inexperienced investor how they would feel about the prospect of losing money versus the prospect of gaining money, they may fear losses more than they value gains. By contrast, a seasoned investor who has experienced the ups and downs of a market cycle understands that portfolio fluctuation is unavoidable – that with greater risk comes the potential for greater gains.

Does this mean the younger investor should have a conservative asset allocation and that the seasoned investor be aggressive in their allocation? Not necessarily. This “feeling” about risk is the psychological component of investing. It’s an important element for you and your advisor to understand because this feeling needs to be attended to sensitively but differs from material reality, which is also known as the ability to bear risk.

Ability to Bear Risk

The amount of risk you can materially bear comes down to a few considerations. For example:

• When will you need to start withdrawing from the portfolio?
• How much capital do you have to invest?
• Are you still contributing wage income to the portfolio?
• How close are you to retirement?
• Is your portfolio balance greater than the amount needed to fund your lifestyle and retirement goals? If so, are you planning to fund legacy goals like inheritances and charitable bequests?

In the example above, the younger investor has a long time horizon, and their primary source of income is their wages; while their portfolio may be small, and they may fear losses, they actually have the ability to bear more risk because they 1) have many years to make up any losses, 2) don’t need to live off their portfolio, and 3) will likely continue to contribute to their portfolio over their working lifetime.

By contrast, the seasoned investor may be retired and living solely off social security and their investment portfolio. Regardless of how optimistic they feel about market risk, they likely have a lower ability to bear risk in their portfolio because it is a core source of income. Protecting the portfolio assets outweighs the benefits of a large potential for gains in this case.

How Much Risk Do You Need?

The third component of your risk profile is something a trusted advisor can help you assess: how much risk do you need to take on to achieve your goals? The answer to this question is the primary driver when determining your asset allocation and usually involves negotiating with the first two factors.

In our example, let’s say the young investor has a long-term goal of retiring early, which creates a need for larger returns. Recall that they have a small portfolio balance, but a steady stream of wage income and do not need the income from their portfolio to live on. We come back to the fact that taking on risk often comes with the potential for reward. In this case, a trusted advisor would likely recommend a more aggressive asset allocation knowing the young investor has a large monetary goal to reach and can bear higher market fluctuation in exchange for greater potential returns. The young investor may need to compromise their low risk tolerance in favor of achieving their long-term retirement goal and take on more risk now.

Similarly, the more seasoned investor has a goal of maintaining their lifestyle throughout their retirement. Although they may feel like they’ve seen it all and could bear more risk, a trusted advisor would likely suggest a more conservative asset allocation to ensure their nest egg isn’t adversely affected by economic events. There is no need to take on additional risk if a lower rate of return can achieve the investors’ goal. A financial advisor can also help each of these investors navigate how their asset allocation should change over time to continue meeting their needs and adjust to their individual circumstances.

Conclusion

Just like there are some people who find skydiving exhilarating, there are others who prefer the safety of staying inside the plane – investors are the same way. There is a myriad of investor temperaments, financial situations, investment goals, and life stages. How these components interlock to create the right asset allocation for your unique situation is one of the most important decisions a trusted advisor can help navigate.