Calculating Risk Tolerance

150 150 Northstar Financial Planners

By Steve Tepper, CFP®, MBA

The investment part of our clients’ financial plans tends to be a simple, yet elegant thing—a low-cost, well-diversified portfolio containing a handful of mutual funds, which themselves contain thousands of individual stocks and bonds.

At first glance, most of our clients’ portfolios look pretty similar to each other.

Among all the differences, perhaps the most important is risk exposure. It is also called market exposure, volatility, or just plain risk. In simple terms, it’s how much a portfolio will rise and fall in value as markets rise and fall.

The academic world gives us a pretty clear picture that over time, a portfolio with a higher risk exposure will have a greater return than a portfolio with a “smoother ride,” fewer big peaks and dips, everything else being equal.

So why even bother customizing portfolios for individual risk? Wouldn’t it be logical to take on as much risk as possible, make the most money, and call it a day?

This would be a short article if that were the case, and if you’ve scrolled down a little, you know that’s not the case, so there’s probably more to it than that.

And there is.

Determining how much risk exposure a client should have in their portfolio, i.e., their “risk tolerance,” is one of the most important steps in the investment planning process, and getting it wrong could have financially disastrous results.

An investor could make a big mistake, like moving out of the market following a large pullback, or run out of money during retirement.

While the end result of the risk tolerance calculation might look simple, the process of getting there can be anything but. That’s because there are several types of risk tolerance, each calculated or estimated in different ways, so one client could have two or three different, and conflicting, risk tolerances.

Mathematical

The easiest risk measure is based on pure math, simple number crunching. If you’re 55 and plan to retire in 10 years, you’re probably going to want to know the answer to one question: “How much money will I need to have when I retire so I can retire comfortably and stay comfortably retired?”

That’s a great question to ask, and as your planner, I’d ask a few more questions to do a very basic calculation.

The inputs into the equation might look like this:

Table 1:
Retirement Assumptions
Starting portfolio balance                     $500,000
Currently contributing                  $1,500/month
Years until retirement                                        10
Retirement income (pre-tax)        $6,000/month
Inflation                                                              3%
Length of retirement                                30 years

From these inputs, we can calculate how much money you will need to have at the end of 10 years, and the required rate of return, or the rate we’d need your portfolio to grow, not just for the next 10 years to get to your retirement dollar amount, but all throughout retirement to generate enough money to last your lifetime.

Table 2:
Retirement Calculation
Required balance in 10 years           $1,229,688

Required return to get there                  6.975%

So, in this simplified example (yes, this is simplified!), your money would need to grow from $500,000 to $1,229,688 in 10 years. You’ll be contributing $1,500 per month (see the assumptions in Table 1), and the rest would come from gains.

You’d need to average just under 7% in gains per year to get to the required Year 10 balance.

From there we can determine how much risk you need in your portfolio to maximize the probability you will get an annualized 7% return (after all costs, taxes, and fees). We’d look at historical returns on various mixes of stocks and bonds to do that.

Table 3:
1972–2012 Historical Returns of 
Stock/Bond Indices
Stocks/Bonds    Gross Return*     Net Return*
100%/0%                     12.97%                10.80%
80%/20%                     12.00%                  9.85%
60%/40%                     10.22%                  8.75%
40%/60%                       9.60%                  7.50%
20%/80%                       8.19%                  6.10%
0%/100%                       6.63%                  4.56%

*Gross return of an index or index composite includes no fees, transaction costs or taxes. The net return includes a 2% reduction in annualized return to account for all of those expenses. Past performance is no guarantee of future returns.

So, what we know from this last table is that a very conservative approach, either investing all in bonds or just 20% in stocks and the rest in bonds, will not, based on historical data, give us a high comfort level that you’ll grow your money enough to fund your retirement. We’d need to go to at least a 40/60 mix and would probably consider going up to 60/40 for a little cushion. (We could also do 50/50 or any mix in between. Those mixes are not shown because, well, a 100-row table.)

We also know a very aggressive approach, like 100% in stocks or even 80%, is probably not necessary to make the numbers work, so depending on how the client rates on other risk measures, we could avoid those higher risk portfolios.

If life were simple, that would be it. We’d do calculations and set up an account, and we’d all live happily ever after. But it’s never that simple, is it? And we’re barely halfway through this article. So, there must be more.

And there is.

Demographic

Risk tolerance is also impacted by your age, income, the stability of income, expected retirement date, and other demographic factors. If you are younger, your portfolio has more time to recover from an economic downturn, so your risk tolerance is higher than someone well into their retirement years.

If your income is high, you can also withstand more exposure to risk because, theoretically, you have greater flexibility to increase your retirement savings to offset losses than someone whose income is lower. The same logic applies to someone with a more stable income compared to, say, a luxury yacht broker who makes sporadic sales but gets a large payday when a sale is made.

As a financial professional, it is my job to determine all of the demographic factors that could impact your risk tolerance, and figure out the proper amount of volatility your portfolio should have based on those factors.

Emotional

By far the most difficult risk measure is based on emotion, and it is every bit as real and as important as the other two more “rational” risk measures. I think of it as this: How much loss can you tolerate in your portfolio before you start losing sleep?

This is critical because if your mathematical and demographic risk measures result in a portfolio that causes you stress, it could lead to a poor lifelong investing experience. You could end up getting scared out of the markets following a big decline, the absolute worst time to sell your investments, or you could see your health and peace of mind decline. Worries about money are also a leading cause of divorce. Do you know any couples who split up after losing a lot of money? I know many.

While it is not an objective measure, a financial professional should work diligently to try to determine a potential client’s emotional risk tolerance. We use many methods with each client, including going through a risk questionnaire; taking them through “what if” scenarios where we show them what might happen to their portfolio if they invested today and tomorrow a long, sharp market drop began; and just listening and watching body language as we talk about risk. I really want to get this right because if I know my clients are losing sleep worrying about their money, I will lose sleep worrying about them. I want everyone to sleep well!

Not Part of Risk Tolerance

I’ve talked about many different factors that are included in various risk measures, and I want to highlight some things I didn’t include:

Table 4:
Factors That Don’t Determine Your Risk Tolerance
•  How high or low stock prices are
•  Elections or anything politicians say or do
•  Gross domestic product, unemployment rate, or any other economic indicator

The point is that measuring risk tolerance is an inward-looking process, based solely on the client’s circumstances. It can change if the client’s circumstance, financial status, needs, and goals change, but should never be impacted by outside factors such as markets, economics, and politics.

Three Measures—One Portfolio

So, after we have all these risk measures, what’s next? Well, if we’re lucky, they all tell us the same story. A 55-year-old needs, say, a 60/40 portfolio to meet his financial goals, has a stable income to support that level of risk exposure, and feels comfortable with the amount of loss he could see on his monthly reports if markets take a big dip.

But the numbers don’t always line up perfectly. If the variations are slight, say a 60/40 mix is needed but the client is only comfortable with 50/50, we could recommend changing some of the assumptions. The client could boost their savings rate or delay retirement.

In the extreme case, a client may need a very aggressive investment strategy to reach their goals but has an unsteady income and/or is uncomfortable with even a moderate risk exposure. If we can’t get anywhere close to a realistic alignment of mathematical, demographic, and emotional risk measures, we may conclude that we aren’t the right advisor for the client. We want our clients to be happy with their investment experience with us, and that begins from the outset, having realistic expectations about a well-designed investment plan that aims to maximize the probability that the client will achieve all of their lifelong financial goals.

Past performance is no guarantee of future results. There is no guarantee an investment strategy will be successful. Diversification does not eliminate the risk of market loss. Investing risks include loss of principal and fluctuating value. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks.
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