How is Your Risk Tolerance Now?: FiLife (a WSJ partner)

FiLife in partnership with The Wall Street Journal
By J. David Lewis

I once had a client with complete sincerity say, “I don’t mind more risk, as long as I am sure I will make more money.”  This concept comes from many finance studies, showing asset classes with greater risk produce greater returns in the aggregate.  Those studies define the term “risk” as variability of return, not simply the probability of value decline, as one might imagine.  While thinking about this article, I happened on a rerun of a Warren Buffett interview, expressing his belief in stocks; while the Dow was below 6,700 earlier this year.  Other pretty famous people, like Benjamin Graham and Peter Lynch have stood by stocks through similar tough times.

If you have an investment advisor, you may have an “investment policy statement,” presumably written specifically for you.  It purports to guide your investment decisions.  Even if you don’t have a formal investment policy statement, you and your advisor should have written guidelines. 

One of the key concepts for matching investments to you is “risk tolerance.”  Doctors talk about tolerance for medications.  They help patients who can endure side effects.  Will your tolerance for risk permit you to endure stress to realize long term returns from stocks?  Presumably you and your advisor assess your risk tolerance and create a portfolio that fits.  There are questionnaires with various levels of sophistication.  At the highest levels, psychologists specialize in assessing risk tolerance.  Sometimes advisors trust their intuitive assessments.  However the assessment, reasonably professional advisors should be able to articulate each client’s risk tolerance. 

That client who clearly expressed willingness for risk illustrates another important point.  Most of his wealth was created from the risk of starting a business.  After holding his securities portfolio through Iraq’s 1990 invasion of Kuwait and that recovery, he had substantial unrealized gains.  Events I don’t remember convinced him the markets would fall.  Triggering approximately $65,000 income tax did not deter him. When he sold he thought he would replace the portfolio at lower prices.  The equities markets did decline modestly for a month or two.  Then they went to many new highs.  The client relationship ended.  A few years later he told me he was still holding the cash.  His risk tolerance had changed. 

People talk about risk tolerance as though it is a measurable constant.  The events of the last two years should improve our understanding of our risk tolerance.  I commend the many people who steadfastly held their portfolios through this period.  I know it was tough.  Some of my most difficult work was helping people suffering raw fear.  Some of these had more than they will ever spend.  Others really needed to stay invested for the recovery we may be experiencing now.  The Dow is up about 34% since our greatest stress.  How did you do?  More important, how will you do when the markets again reach peaks and decline?  Could an investment policy statement and a committed advisor help you through the next stressful market?

Recommended Posts