The last article in my series on financial planning opportunities during COVID-19 discusses reviewing your investment risk and the need to review your risk tolerance. So far we have looked at revisiting your goals, reviewing your expenses, and looking into tax planning opportunities. This article will wrap up the series.
First, what is investment risk?
Investment risk, in a basic sense, is the risk that the performance you actually get on your investments over a specific period of time will differ than what was expected, due to a multitude of factors. The higher the level of risk, the higher the likelihood that this variance between expected and actual will occur.
So, for example, cash has one of the lowest risk scores (notice how I didn’t say cash was free of risk – I will talk more about this in another article). Think of your current balance in your checking account. You know that when you wake up tomorrow, the cash that was sitting in your account will not fluctuate in value (unless of course you make a transaction), and you will have the same amount as you did yesterday. The variance between what you are expecting to be there and what will actually be there is very small to nothing.
On the opposite end of the spectrum, a completely speculative investment may get an above and beyond return or may leave you with absolutely nothing to show for it. The variance between actual and expected could be significant.
Risk and return are typically an inverse relationship. The higher a risk level is, the higher the potential return. The lower your risk level is, the lower your potential return. Going back to your checking account – you are not taking a significant risk with that, therefore your return is minimal. You may be getting a .01% rate on that investment.
For additional articles that discuss investment topics in more detail, check out this section of the site.
So, what is risk tolerance?
Before you review your risk tolerance, you need to be familiar with the concept. Risk tolerance is the level of risk, in other words the level if variance between expected versus actual returns, that an individual is willing to take with their money. This level could be based on their personality, their reliance on their investment for living expenses, their cash flow needs, age, or time horizon available to invest. Risk tolerance is complex to determine, and we spend a lot of time on this with our clients.
To give an example, a 30 year old’s 401(k) with their employer will have a much different risk tolerance than a 75 year old’s account they rely on for their everyday retirement income. The 30 year old’s 401(k) has much more time to weather any market variances, they normally aren’t relying on the account right now for cash flow needs, and are continually contributing money into the account which can take advantage of market fluctuation. The 75 year old’s account has much less flexibility to be able to fluctuate – this person relies on that money and at the end of the day, needs X amount of dollars from the account no matter how the market performs. The risk tolerance for that account is much lower.
How do risks affect my financial plan?
With changes COVID may have brought, it’s important to review if your investments are still aligned with your goals and your plan – review your risk tolerance. I have seen all too many times of people with self-monitored portfolios that are too risky for their intention, there is a market correction (such as we saw in March and April) and they must adjust their lifestyle because their account values fluctuate too much for their current goals.
An example, did you decide to retire earlier due to COVID changing your industry or you received retirement incentives? Your portfolio may need to adjust in order to be able to provide you the retirement income you need sooner than intended.
Did you reduce your expenses because you’re now working from home? You may want to bump up your 401(k) contribution and look to see if your 401(k) is set up with a longer-term risk perspective.
Did you purchase a home upstate and are planning to take a down payment from your investments? You’ll need to adjust accordingly to make sure that money is there for you when you need it soon.
Review your Risk Tolerance – Summary
Especially now, I recommend reviewing your overall portfolio risk and assessing this with an advisor to determine if your risk level makes sense for you right now. From a financial plan perspective, this will help assess the amount of return needed to achieve your goals in your financial plan, and determine if your risk tolerance and this needed rate of return aligns. If it doesn’t, then a discussion and adjustment to the plan is needed.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Marshall & Sterling Wealth Advisors, a Registered Investment Advisor. Marshall & Sterling Wealth Management and Marshall & Sterling Wealth Advisors are separate entities from LPL financial.
Opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations. To determine which investment may be appropriate for you, consult with your attorney, accountant, or financial advisor prior to investing.
Can risk tolerance level can be assessed for insurance buying decisions and for debt decisions also. is there any separate questionnaire for measuring risk tolerance for other financial decisions i.e. insurance and debt decsion.