Reminders for a New Year: Risk Tolerance Shouldn’t Change With Markets
One of the questions we’ve/I’ve had from clients during the prolonged bull market is: how often should I change my risk tolerance?
The answer: Not often.
Risk tolerance is the personal comfort level that an investor has with financial risk in the markets. In the most basic sense, it is your ability to stomach swings in the markets in exchange for potentially higher future returns. Risk tolerance doesn’t tend
to change dramatically over time. Consider the answer to this question: How would you respond to a 15 percent drop in your investments? Most people’s reactions and levels of comfort in this situation would likely not vary over time.
Risks Are Inherent When Investing in the Markets
Investing is never without risk, and market ups and downs are a natural part of the investing journey. While risks in investing can never be eliminated, they can be managed. This is one of my/our main roles as (an) advisor(s)—to act as a risk manager(s). As (a) risk manager(s), I/we have significant concern and care for preserving your capital and growing it over the longer term. I/We put this into practice when I/we construct and manage portfolios, positioning them so they are resilient in any one particular outcome, but also have the chance to do well across the many potential paths the markets can take.
During buoyant market periods, such as the recent extended bull market run, the need for risk management may not be overly apparent. It may have been easy to get caught up in the prevailing momentum. Yet, risk management does not focus on achieving the highest possible rates of return—it is about preserving hard-earned capital to support investors in achieving the returns needed to accomplish their goals. Often, it’s only when prices head downward that the value of risk management
becomes more obvious.
This means following various guidelines that have been established to control risk. I/We do this in various ways, such as maintaining a strategic asset allocation, rebalancing portfolios back to target allocations when they drift too far, limiting the size of any particular holding, diversifying exposure across sectors and geographies, and paying particular attention to an investor’s personal risk tolerance levels.
When Does Risk Tolerance Change?
With time and evolving circumstances, however, your capacity to take on financial risk may change. This is your ability to withstand a financial shock, and it may have an impact on your risk tolerance. Here are events that may impact risk capacity:
- A major life event, such as marriage or birth. Marriage or the birth of a child may lower your capacity for risk as you account for large expenses, such as a new home or a child’s education. Often, spouses can differ in their risk tolerance levels. Some studies have shown that men tend to have a higher risk tolerance than women, so common ground may need to be reached when managing finances.1
- A health crisis. Unexpected medical bills or changes in your ability to generate income may impact your timeline and ability to achieve your financial goals.
- Changes to net worth or income. Your level of wealth may impact your capacity for risk. For instance, the greater your excess income, the easier it may be to weather a downturn without it affecting your lifestyle.
One Reason To Adjust Risk Tolerance: Age
As you age, changes to risk tolerance levels can be expected. You may become more risk averse if you do not have the same sources of income and need to preserve wealth within retirement. With a shorter time horizon, recovering from market volatility may be more challenging, which may prompt you to lower your risk tolerance level.
One Reason Not To Adjust: Fluctuations in the Markets
Your risk tolerance should not fluctuate based on market conditions. Changing your risk tolerance in response to market performance can be seen as similar to attempting to time the markets by buying and selling shares. It may be tempting to lower your risk after you have incurred a loss, just as you might want to raise your tolerance during periods of continuous market advances. But the performance of the markets, and the emotions of fear or greed, should not be a cause to reevaluate your
tolerance for risk.
Please Get in Touch
If you have any questions about this, or any other investing matters, please call.
1. https://www.advisor.ca/practice/planning-and-advice/how-gender-andrisk-tolerance-affect-advice/
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