Investment Fundamentals

What's your risk tolerance

What's your risk tolerance?

Background

For an SMSF investor, understanding their risk tolerance (or risk profile) is another very important piece of the investment puzzle. It reflects how comfortable they will be with the risk they are likely to encounter when investing in the assets that are capable of delivering the kind of returns they are after.

Risk can come from a number of sources, including geo-political unrest around the world, economic slowdowns, changes in interest rates and a range of others.

And as we discussed in the Risk & Return article, risk is also implicit in the asset class (or type) of investments held, as well as the risks that are specific to each individual investment.

All of these risks however have one thing in common – they can negatively affect either individual investments or indeed an entire portfolio, and can sometimes do so quite substantially.

Risk tolerance

The big question is this:

What is your tolerance to risk ?

In a nutshell, this refers to an investors ability to both financially and emotionally handle a fall in the value of either an individual asset, and more importantly, their overall portfolio value.

For instance, if an investor bought shares in a company today on the ASX, and tomorrow they reported a fall in profits, and the share price fell 20 to 30%, would they be OK with this ? Sure, they wouldn’t like it, but could they accept it as a normal part of the risk of investing in shares and move on ? Or would that sort of scenario just be entirely unacceptable to them? Their answer to these questions help dictate what asset classes they could invest in and which ones they may need to avoid.

Now think about an entire investment portfolio. What sort of volatility can they handle? If say share markets around the world became stressed, and these broad markets themselves fell in the order of 10%, 20%, or even up to 50% in rare extreme cases, could they handle this type of outcome in the short term. Again, no-one likes it, but can they deal with it in a rational manner ?

Is the investor able to stay relaxed if their account balance fluctuates when risks manifest and cause negative returns? Or would they become very nervous and anxious if their account shows even a minor dip in value ?

Time is often the key

Remember in the first article in this series, we talked about investing for goals, and how they have different time frames.

This is important, because this will play a large part in dictating an investors risk tolerance for a particular investing situation.

For example, investors with short term goals will generally have a low risk tolerance, as they need a more certain outcome. Hence defensive assets will be appropriate for short term goals.

On the flip side, when investing for the long term, such as with a SMSF with many years until retirement, a higher risk tolerance can be implemented as the longer the time frame, the higher the probability becomes that the higher returns from growth assets will be realised by the investor as they go through multiple investment cycles (ups and downs).

Stage of life is also important

In addition to an investor’s ability to handle volatility, the other key variable that can influence an investor’s risk tolerance will be dictated by their stage -of-life (which is closely related the “time” issue above).

For example, a younger person with 30 years until retirement may be quite happy to ride out the fluctuations in financial markets, given they are still working and have many years ahead of them to recover from any significant downturn in markets.

Contrast this with say an older investor who has just reached retirement. This investor does not have the luxury of time to make up for significant losses, but rather has an immediate need for income and capital stability to fund their retirement.

As you can see, these scenarios are very different, and generally result in a difference risk tolerance.

In the next article in the series, we’ll look at the benefits of diversification, and how this can reduce the overall risk in a portfolio.

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