The Three Components of Risk
By: Sam Swift, CFA, CFP®
There’s a lot of emphasis on risk in the financial world, and with good reason. The fundamental truth of investing is that risk and return are related. The more risk you take on, the higher the expected long-term returns; the less risk you take on, the lower the expected long-term returns. I’ve argued in the past that volatility and REAL risk to a financial plan are two different things, but it’s still worth diving into how one should make the decision to take on portfolio volatility.
There are three components that should factor into determining the appropriate portfolio allocation: your ability to take on risk, your willingness to take on risk, and your need to take on risk.
Your ability to take on risk is largely determined by the time frame of your goals. A young investor with twenty years until retirement has a high ability to take on risk. Short-term volatility in that case becomes largely irrelevant as almost all twenty year periods have experienced consistent, positive returns. On the other hand, an investor focusing on a college fund for their 17 year-old child has much less ability to take on risk. Yearly market returns can vary significantly and that investor cannot afford to see their college fund significantly reduced in value just as the money is needed.
Your willingness to take on risk is much more subjective and ties into the behavioral aspect of personal finance. If you’re the type of person to lose sleep when your investments are losing value, then that’s pretty important to know. Perhaps you’ve run across a “risk questionnaire” at some point. Those actually address the willingness component fairly well, but unfortunately are often presented as all encompassing. Because of this, they are often a running joke around our office as a rather lazy way of picking a portfolio allocation.
Are you risk-tolerant? Or are you risk-averse? How risk-averse are you? Do you feel anxious if your investments lose value? Has your appetite for risk increased or decreased over the last five years? If your investments lose 32% of their value in one year, are you more likely or less likely to cash out your investments, sell your home, ditch your family, and establish a gardening commune high in the mountains?
Okay, I may have embellished that last one, but these are fairly standard questions and you can see how they may help you work through your own willingness to accept risk. As long as you use the questionnaire with the understanding that it is gauging just this one component of your risk decision, then they can actually be somewhat useful. Just remember to weigh the results accordingly.
Lastly, and most importantly, you must establish what level of risk you need to take in order to meet your goals. As we established earlier, risk is directly related to return. Lofty goals may require high returns and a corresponding high level of risk. For example, a retiree may have a strong desire to double or triple their assets for inheritance which would require more short-term volatility in an effort to capture higher returns and achieve the goal. Conversely, the same retiree may have no desire to leave an inheritance and require only a 2% withdrawal rate from their assets to comfortably live the lifestyle they would like. That client would need little risk, if any, in order to meet their goals.
Ideally your ability, willingness, and need to take on risk will match, but serious conflict can arise when these three components are not in sync. Perhaps you’re young (high ability) with the goal of early retirement at an elevated standard of living (high need), but you’re very uncomfortable with any short-term drops in portfolio value (low willingness). This will probably result in either a reevaluation of your goals since they aren’t achievable with a low risk portfolio, or an alternate solution (save a lot more now).
In another scenario, maybe you’ve underfunded the education account for your child and now they’re a junior in high school and will be using that education money up in the next five years. You have a high willingness and a high need to take on risk, but your ability to take on risk is relatively low.
There are rarely easy answers when the three determinants or risk are in conflict. However, with a clear understanding of how each applies to your situation and by planning early and often, you’ll have the best information available to make an educated decision.