Not All Risk Is Created Equal
Risk is a personal (and funky) thing when it comes to investing. Generally, it’s formulated with years of experience (good, bad, or indifferent) which leads us to our risk profile. One of the biggest components in investment risk-taking is a good education with facts and figures, and not one’s emotional experiences. That information can lead to formulating an accurate risk tolerance.
What do you need to know about risk? For starters, not all risk is created equal. There are different types of risks when it comes to investing. At Diversified Lifelong Advisors, we often discuss the two main types of risk to consider when designing a comfortable asset allocation. Each individual eventually lands at the appropriate balance.
Let’s analyze the two main types of risk.
Risk Willing to Take – The more common risk we’re all familiar with is the risk we’re willing to take. We have a cool questionnaire that we can send clients which quantitatively helps determine their risk level. There are plenty of ways for individuals to see risk they’re willing to take. There are drawdown discussions we can talk through. What’s the maximum amount you’re able to see your account go down in normal market conditions and be alright with? There are volatility dialogues we can also have to walk through expectations and comfortable levels in these circumstances. The bottom line is “risk willing to take” is very common and generally how most investors have determined their asset allocation between stocks and bonds.
Risk Able to Take – This is the less common risk typically discussed. On the surface, it may seem fairly similar; however, there is a big (and not so subtle) difference. A person’s ability to take risk is actually quite different than their willingness.
For instance, Mr. Client is retired and his expenses are covered through pension and Social Security. This person is in a completely different position than an individual relying on their investments to provide retirement income. This individual actually has the ability to take as much risk as possible, as these funds are insignificant to their financial health. Maybe he wants to provide a legacy for his kids or grandkids. In any case, this person is able to take an enormous amount of risk.
On the flipside, someone who has a bunch of money needed for a down payment on a new home in three months is on the opposite side of this equation. I’ll often get the question, “What should I do with these funds? I’ll need them in three months?” My answer is always high yield liquid savings. Why? Because this person isn’t able to take risk with these funds. If the balance drops even by 10%, they simply can’t buy their dream home. You see the difference now?
Practical Use
This is why financial planning, and more specifically investment management, is a kind of artform. It allows for one-part science and one-part art. Many times, a good approach is to bucket one’s investments for different goals. This allows someone to specifically allocate certain funds to be aligned with their risk, certain funds to take on more risk, and certain funds to take on less risk. Each “bucket” has a specific purpose and thus runs through a different set of risk variances. I am a big proponent of this method. (A good example is college funds, especially for a student in college. We may have a client’s 529 account at very little risk, while the rest of their investments are much heavier on the risk spectrum. These dollars are really close to being used, so we opt to lessen the volatility exposure.)
Risk is a Sensitive Subject
Risk touches the core of our emotions. It elicits strong feelings and is often nearly impossible to judge what’s appropriate if left to our own devices. I’ve seen a lot of people misallocated through the years, and it’s usually unbeknownst to them. It takes a tragic event to unravel their true risk alignment, unless we get to them first.
I hope this is helpful and certainly don’t hesitate to reach out if you need a risk tune-up.
