Measuring Risk Tolerance Is Not Financial Planning

Market cycles, bull and bear, have considerably more impact on our psyche, confidence, and outlook than we perhaps realize. When stocks have risen for a period long enough for us to believe the trend will last, things simply look brighter. We feel more confident about our future, loosen our grip on our money, and feel more comfortable taking risk. With the the Total US Stock market up some 200% since March of 2009, we have had numerous discussions around increasing stock exposure to capture larger returns – it’s only normal.

But try to remember how you felt about stock market risk in the midst of the Financial Crisis of 2008 and ’09. As an advisor working with scores of clients, I can tell you, very few felt bright or confident about their future and none of them were eager to take more risk by increasing their allocation to stocks.

It is a fact of our human nature that our tolerance for risk changes with our circumstances and outlooks, particularly when we believe markets will continue rising or falling for a significant period of time. When stocks have fallen for a number of months we focus more acutely on losses and the risk of losing more. Alternatively when markets are rising, we begin to worry about missing upside returns and are tempted to take increasing amounts of risk to capture larger gains.

Consider the tables below. They represent the six month return characteristics (95% of the time) of two portfolios. The one on the left holds 60% stocks, 40% Treasurys and cash, while the one on the right holds 90% stocks and 10% Treasurys. Which side of each table draws your primary focus – the green upside or the red downside?

The last six years’ out sized stock market returns may compel you toward increased stock market exposure (right) with its higher potential returns. Recent declines or memories of the Financial Crisis of 2009 and the S&P’s decline of 53% may likely evoke the opposite effect. From a more pessimistic vantage we would likely focus more on the potential losses in red than the potential gains in green. In fact, you may not even consider the upside numbers in green.

While the question of how much risk you can stomach is an important one and one that will change as markets and personal circumstances change, it is NOT the most important part of the risk question. The most important question is how much risk is required to meet or exceed the important life goals for which you invest?

The tables above provide no information to help with this question. In fact, without the guidance of goals and where one stands relative to accomplishing them, the focus on risk tolerance alone can disastrously counterproductive. As we have seen, in good times we tend to overshoot on risk and in bad times we tend to undershoot. With no measure of the APPROPRIATE amount of risk we are flying blind.

Only by setting goals and priorities can we begin to understand how much risk is required to meet or exceed them. Our tolerance for risk will vary, but sound financial planning is equipped to handle these changes. It’s far better to implement your investment plan based on a level of risk that is appropriate than it is on a level that offers you as much risk that you said–perhaps many years ago–that you could stomach. It is an absolute certainly that in time the stock market and your risk-full portfolio will indeed test your ability to stomach it’s full measure.