We take risks every day in life. This was never more apparent than during the pandemic. Even routine tasks like going to the grocery store became fraught with risk-return tradeoffs, such as deciding to go in the store or order for pickup. Perhaps you went from a routine of checking your portfolio monthly to looking at it daily in March of 2020, resulting in watching your portfolio fall and recover like a stomach-wrenching roller coaster ride. Defining your personal comfort with risk, financial or otherwise, is a necessary trait to making important decisions and moving forward in your life goals. When it comes to investing, recognizing the risk required to achieve the rewards may not be fully understood until you are in a period of extreme volatility. This is like sitting on the roller coaster and determining if you will come to the end of the ride with your stomach intact.
Your willingness to take on risk for the uncertain benefit of achieving a positive outcome while recognizing the potential for a negative outcome, is an academic definition of risk tolerance. The discussion around risk tolerance is always part of the portfolio conversation. However, at AWMI, our approach to incorporating your financial planning goals into your investment portfolio goals allows us to consider some other aspects of risk that play into finding your best plan of investment. We typically refer to this as optimizing your portfolio.
Consider your risk capacity. This is your ability to survive a financial loss without impacting your long-term financial goals. You likely have the capacity, in actual dollars, to be able to afford to take the risk to be invested, even in markets like 2020. Another way to look at your risk capacity is how much risk you must take to meet your goals. Most of us cannot afford to be holding cash, or even a very conservative portfolio, especially considering the impact of inflation, our ability to save enough, or even our ability to further our financial status. Through AWMI’s planning process, we can help define your capacity to take on investment risk to meet your financial goals.
We recognize that just because you can or need to take on risk, you may not want to. This is your risk perception. How you perceive risk is your subjective judgement about the characteristics of that risk – what you think might happen. People with better risk composure typically maintain a consistent perception of the potential risks surrounding them. However, a constant barrage of negative scaremongering, such as overwhelming media coverage, can cause a disconnect with the true likelihood of an outcome, creating our “mis-perception” of the potential outcome. If you only focus on the worst-case scenario, this can cause you to have inconsistent behavior with your risk tolerance and risk capacity. Better information about the risk reward tradeoff is one way to combat inconsistencies with your risk perception. Now you know why we sent out so many emails at the height of the market volatility during the pandemic.
Looking back at the pandemic and the extreme market volatility last year, you can pat yourself on the back for surviving 2020. Dealing with more extreme forms of risk, such as demonstrated by the pandemic, allows us to strengthen our risk composure. By improving our comfort with risk, we enhance our ability for rational decision-making to accomplish our goals, including our financial goals.
Cathie Straub, CPA, CFP®
Director, APCM Wealth Management for Individuals
Acknowledgement to Michael Kitces for his work on risk tolerance, capacity, and perception