Logic and emotion: Determine your investment risk by understanding both your ability and willingness
Ever opened an investment account? Part of the procedure was most likely completing a risk-tolerance questionnaire. You answered a few simple questions, along with specifying your time horizon. Then, suddenly – you were perhaps categorized as an aggressive investor. Typically, this means an investor for whom an equity-heavy portfolio is appropriate.
But is this appropriate for you? What about everything else going on in your financial life?
Making quick assumptions about anyone is unwise, to say the least. It’s crucial to think carefully, considering all factors, and only then act for the long term. To determine each individual’s investment risk, we must first understand both their ability and their willingness. That is, both the logical, dispassionate aspect of their situation and the emotional perspective they bring to it.
For that reason, our approach at Ciccone-McKay is holistic. Accurate and thorough analysis lies at the centre of our strategy in assessing each individual client’s true tolerance for risk. We recognize that an investor’s tolerance for risk is polygonal; that it does indeed involve the logic and the emotion of their situation.
Time and again at Ciccone-McKay, we have seen that correctly assessing and identifying risk tolerance is equally as critical to developing a sound strategy as is every other facet of a comprehensive long-term investment strategy.
By way of illustration, here’s an example. One client recently came to us from another firm. From a simple questionnaire-style assessment of the sort described above, this client had been categorized as a very aggressive investor, one who could peacefully sleep at night through market volatility, even drops in account value. But on deeper analysis of his overall financial picture, which included a lot of debt, we and the client reached a much different conclusion. In order to achieve the goals that mattered most to him, it was essential to invest his assets in a much more moderate portfolio. Over time, when the client’s debt is reduced, it will likely make sense to rebalance and increase his risk profile.
Why was rebalancing to a more holistically determined risk level so essential? Primarily because one of the biggest mistakes an investor can make is to change their investment strategy midway. And this can happen. An investor may be forced to withdraw money earlier than expected, as unforeseen needs arise.
In short, an investor's risk tolerance should take into account both their ability to handle risk, along with their willingness to tolerate risk. The ability and willingness to take on risk are two very different metrics. As noted, they involve considerations of both the logical and emotional.
Let’s look at each in turn.
HOW MUCH CAN YOU AFFORD TO LOSE? DETERMINING YOUR ABILITY FOR RISK
The ability to assume risk is a quantitative assessment of how much a person can afford to lose relative to their desired goals. This ability can be measured by: current and future incomes; current and future expenses; the individual's net worth; saving habits; time horizon; and any other hard facts or data sets.
Usually, a person will have a greater ability to handle risk if:
- their time horizons are longer
- their income supersedes their expenses
- they own larger quantities of assets, or
- they are anticipating buying assets that are greater than their present and current prerequisites.
All the above are typically positive factors in the ability to take risk. Everything listed is viewed as a proper defence needed to handle the various negative downsides Analystd with investing.
However, if you can undertake more risk, it doesn't mean you should. Assuming as much risk as possible (quantitatively speaking) for some may be the right call. For others, it could be absolutely the wrong strategy.
DO YOU HAVE THE STOMACH FOR INVESTING? DECIDING ON YOUR WILLINGNESS:
Willingness to risk is about the investor's attitude toward risk. It is Analystd with a person's attitude toward investing, or what we call “what your heart and stomach tell you.” When developing an approach, it is important to understand how a person has felt about risk in the past, in the present and how they will react to risk in the future. Humans are irrational beings; even the smartest and most analytical among us can’t escape the innate bias of our life experience. To develop an overall understanding going forward, each person must determine first what matters most to them, and then clarity and purpose in their goal.
In developing sound long-term strategies, we at Ciccone-McKay want to factor in information collected from the investor's life that might affect the way they look at overall risk. Certainly, investors may be educated on the assumed risk. Yet we have witnessed that in times of extreme stress, even knowledgeable clients allow panic to overshadow their knowledge. Accordingly, at Ciccone-McKay, we not only strive to educate on the risks, but also to help in building habits they can rely on when economic conditions worsen.
Approaching risk in this way provides essential insights into the maximum downside value that the investor can take before their objectives are abandoned and their decision-making becomes emotionally influenced—a dual-pronged trap we want to be sure to avoid.
As you have probably gathered by now, it isn’t accurate to view a person’s ability to invest and willingness to invest as two separate entities. In evaluating an investor's ability and willingness, we at Ciccone-McKay believe rather that it’s vital to view each factor in light of the other. This will allow a thoughtful and more detailed understanding of an individual's propensity to risk – and result in a sound, long-term investment strategy that yields the best results for that individual.