What’s your risk tolerance?

As investment advisors, we spend a lot of time with clients talking about risk, so investors are not caught off guard when market values drop. No one complains when markets are positive, but it is natural to experience an increase in clients’ calls when markets decline. There is a difference between how clients reply when questioned about their reaction to a fictitious 10% decline in their portfolio, compared to reality when they actually experience such a decline. Knowing your risk limits prior to committing money to an investment plan is crucial to avoid some mistakes which investors make.

As in most life situations, planning is key before committing to investments. Ideally investors have a roadmap which details how they intend to invest, to reach their investment objectives. The planning stage is split in different stages. Each stage is vital to understand clearly where the investors intend to go and what type of portfolio they are happy with owning, in order to achieve their investment objective or different objectives.

One important stage is identifying the risk tolerance. In short, this is the ability of investors to withstand losses when their investments decline in value. This assessment of risk tolerance paves the way to the type of assets investors will own in their portfolio. An investor with a low risk tolerance will have a preference for investments which have historically experienced minimal fluctuations, and as a result you should expect a higher allocation to cash and short-dated higher quality bonds. On the opposite side, an investor with a high risk tolerance will prefer an allocation to more volatile assets, such as equities, which usually outperform other asset classes over the long term.

Very often an investor’s risk tolerance is represented in the form of a score or numerical figure. This is achieved after the investor replies to a set of questions. The questionnaire is made up of two sets of questions. Some of which revolve around the individual’s personal circumstances while others try to gauge the investor’s reaction during negative market periods.

While replying to these questions, investors should be honest about their replies related to risk. They should not reply as they think an experienced investor would. Investors and investment advisors should keep in mind that the risk tolerance questionnaire should not be seen in isolation and hence it is not intended to be the sole guide to what investments or asset classes should be included in a portfolio.

Therefore, the risk tolerance score should be considered in conjunction with the investors’ investment objectives, time horizon and other personal preferences. Therefore, it is not correct for investment decisions to be based solely on the risk tolerance score achieved. An investor may achieve a high risk tolerance score because naturally he is a risk taker, but his time horizon might not support investing in highly volatile assets, because he needs the sum available for investment within a relatively short time frame.

With this in mind, it is paramount that at planning stage investors identify the differences between their willingness and ability to take risk. A 35-year old professional with a decent income and commitments in check, may have the ability to take risk but lacks the willingness, because he is not keen on experiencing market fluctuations. On the other hand a 55-year old may have the willingness to take risk because she is an experienced investor, but given that she is some years away from retirement her ability to take risk is low. While these are text book examples, in real life it is common to come across investors who opt for a portfolio mix which is safer than what they are actually able to tolerate.

An example which comes to mind is a business man in his mid-forties, who is an experienced investor, tolerates market fluctuations and who is well versed with the investment industry. Despite his ability to take risk, he is not willing to put his capital at risk because he considers the money invested in his business as the risky portion in his portfolio.

In my opinion this reasoning makes a lot sense. It supports the idea that an individual investor may allocate capital across different risk buckets. Despite having one risk tolerance score at a point in time, investors could possibly hold a portfolio of assets which is split across different risk buckets. Each bucket has different investment objectives and time horizon.

The investor mentioned above has a high risk tolerance score, however he is only willing to allocate a portion of his wealth in what he considers the high risk bucket, and that is his business. On the other hand, he is not willing to invest, any other financial wealth which he accumulated and not going back in the business, in volatile asset classes. This despite his ability to invest in volatile assets, which will potentially generate higher returns. As a result, he has assigned a risk bucket for this part of his portfolio which is relatively low risk and which carries low volatility, and hence in line with his lack of willingness to risk.

Planning to reach your financial goals is paramount in avoiding unnecessary stress which market volatility can bring about. Risk tolerance will likely change with investment experience, knowledge and age. It is not determined once for life. Knowing your risk tolerance for different investment objectives will help you manage your risk better and avoid panic selling when market volatility increases. If market declines keep you up at night, it might be time to reconsider your risk tolerance and to adjust your portfolio to reflect assets which are less volatile and more in line with your risk tolerance.

Gabriel Mansueto is the Head of Investment Advisors at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]