Do you feel an oversized dread for something as unlikely as a shark attack, yet feel safe driving a car?
What makes something feel risky?
What is your personal tolerance level for risk?
We worked with a client recently who had just celebrated a big round birthday number, just a number, but it affected her risk tolerance. Another client was affected by a real estate investment that went south at the same time that his stock portfolio was swooning with the markets.
Why do we care so much about this topic? Because we want clients, like you, to avoid making the wrong choice at the wrong time if your risk thresholds are crossed.
Fortunately, when it comes to personal finance, lots of research has been done on risk. To help our clients learn about their own risk tolerance, we use the FinaMetrica Risk Profiling System* that has been administered to over 300,000 investors.
The FinaMetrica research identified four important components of risk. They are:
1. Risk Required
2, Risk Perception
3. Risk Capacity
4. Risk Tolerance
What is the Risk Required? No one really goes out and seeks risk for risk’s sake. We accept risk in exchange for some reward. That could be a thrill or it could be an expected financial return. We accept the risk that is required in order to pursue a needed return. For example, inflation over time poses a risk to purchasing power. From postage stamps to gasoline to housing, inflation has driven costs up and we ‘require’ our ‘investment’ rate of return to be at least as much as the inflation rate.
Risk Perception is what changes over time. We tend to think our neighborhood is less safe after a burglary down the street, but in fact the opposite is probably true. In all likelihood the thieves will now consider the neighborhood too hot and will be somewhere else. This recency bias is very hard to overcome. We saw this firsthand when, in March of 2009, we got some very strange looks when we told clients we were going to rebalance and buy more stocks after they had just watched the major equity indexes lose half their value.
Risk Capacity is the part of risk that is usually discussed with a financial advisor. It can be numerical to the point of being clinical. Risk capacity determines how much risk needs to be taken. Those with significant funds can afford to take lower risk while investors who require more funds to reach their goals might have to take on more risk to succeed.
Risk Tolerance is where the rubber really hits the road. Tolerance is individualized and situational. It is about how you deal with having to go to plan B, when plan A doesn’t work out. It factors in natural levels of optimism/ pessimism, your confidence in your ability to make financial decisions, and, yes, how well you sleep at night. This is the hardest part to get right. If we have extraordinary conditions, most of us have less risk tolerance. We’ve learned to factor in outside influences when trying to set the mix of investments for our clients – including the birthday celebrant and real estate investor mentioned above.
At the end of the day, we want our clients to have both good results and a great experience. Please use the FinaMetrica link provided here or contact us if you would like to refresh your scores. Feel free to forward this if you know someone else who may benefit from such an assessment!
* FinaMetrica is an Australian firm that has worked with university researchers on pioneering work in how investors view financial risks.
