At the start of any investment journey, if you were sitting down with a financial adviser they will lead you through a series of questions to understand your risk tolerance. But, let’s say you’re doing it yourself, then you could do worse than go looking for the best risk tolerance questionnaire available.
From risk management to risk profile
Risk management is a big subject and can seem a little esoteric at times. Large organizations employ teams of people just monitoring and managing risks. In the field of personal investing, things are somewhat simpler though just as important for the person doing the investing.
If you have encountered risk management in an organizational or business setting you will know it starts by identifying risks across all sorts of different internal and external areas and mapping them out in terms of the likelihood of occurrence and severity of impact. Then looking at internal organizational controls and mitigation measures. A couple of examples would be the risk of bankruptcy of a critical supplier or the risk of accounting fraud.
Fortunately, developing a risk profile for personal investing is less complicated than managing risks in an organization or a business. However, both share the common feature that the process of internal dialog on the subject of risks is equally if not more important than any conclusions or report that may be produced.
The main purpose of a questionnaire about risk is to have a conversation with yourself and your financial adviser, if you have one, to build a risk profile that will help guide you in the choice of suitable investments.
One of the primary challenges of using a sequence of questions to build a risk profile for personal investing is the need for a commonly accepted vocabulary. We need to agree on the meaning of terms such as “conservative investment strategy” or at the other end “aggressive investment strategy”.
There is inevitably going to be a learning process. As the individual gains an understanding of what these terms mean and how they apply to his or her investment plan. Even a short way down the road there may be a need to reassess and possibly adjust the plan if the fit wasn’t optimal at the outset.
Risk tolerance in personal investing
Risk tolerance is just one part of the picture making up your overall risk profile. Risk tolerance is how much risk you feel comfortable with before you get to the point where you could no longer sleep at night.
But let’s remember, the higher the risk the higher the reward. So If you only accepted risks that you were completely comfortable with you would limit the rewards you can achieve. For this reason, a financial adviser will usually seek to include investments in your portfolio whose risks come up to your risk tolerance limit.
While risk tolerance is how much risk you are willing to put up with, risk appetite is the other side of the same coin and means how much risk you would want to take on. If I could use a gambling analogy, you won’t find many people who go for a day at the races and then are only willing to risk a bet on the favorite for any race.
OK, that was an unfortunate analogy and I am not saying that investing is or should be like gambling.
Risk capacity is your capacity to manage risk given all the other parameters of your investments and what you need from them. To get into all those other parameters we should run through the question areas that need to be covered.
What is your investment time horizon?
This is the time horizon for building capital so is it 1, 3, 5, 10, or 15 years or longer?.
The period over which you want to receive withdrawals?
This will start once you have built capital and will continue typically for several years. In the case of retirement, it would run to the end of your lifetime and your partner’s lifetime. In the case of saving for college or the down payment on a house, it would be for a set number of years or a lump sum at a point in time.
What is your primary investing objective?
Some answers to this question would include:
- To preserve capital
- To build capital
- To provide a stable income
- To speculate
- To provide a legacy
Annual income expectations
You should then be asking yourself how you expect your income to change over your investment time horizon and through the withdrawal period. Possible answers could be: no change, gradual increase or decrease over time, large increase or decrease over time.
Anticipated major expenditures
In the case of building capital over a long time for retirement, you also need to consider if there are any large foreseen expenditures in the pipeline, such as paying for college.
Socially and environmentally responsible investing.
This is another important area of questioning. Many people will want to have some or all of their portfolios invested in socially and environmentally responsible companies or may wish to exclude investments in certain kinds of companies or industries.
Now we come to the tricky bit. You will need to get a handle on how you deal with downside risk. This might seem obvious but getting this part right is key to the whole process.
If your aversion to loss is over-estimated then this will put you into investments that are too conservative and will likely only deliver low gains that may even struggle to keep pace with inflation.
If on the other hand your aversion to loss is under-estimated and you enter investments that are too risky for you, your portfolio will likely experience sharper downturns now and then which could prompt you to lose faith with the plan and jump ship.
Either over-estimating or under-estimating your loss aversion can result in you abandoning the plan halfway through, either over frustration at low returns or anxiety over occasional setbacks in portfolio value.
Asking the same question from multiple angles
The answers to most of the previous questions are going to be hard numbers or clear objectives. When it comes to assessing risk aversion and risk appetite because these are sensitive issues that touch on fears, psychology plays an important part.
How questions are framed will steer you, as the respondent in one direction or another. An obvious example of essentially the same question framed in opposite ways would be:
Question 1. Do you not accept the possibility of a loss in the value of your investments, while that means the probability of lower gain?
Question 2. Do you accept the possibility of a loss in the value of your investments, while that means the probability of higher gain?
Since we have a natural tendency to agree with whatever position the questioner is coming from the responses to question 1 will be skewed towards not accepting the possibility of loss while the responses to question 2 will be skewed towards accepting the possibility of loss.
A good approach is to ask the same question from multiple angles ensuring that you have a good mix of positive slant and negative slant. Even then the order in which such questions are asked can skew results. Following best practices in the formation of questionnaires, using a Likert scale approach, a questionnaire could look like this.
Instructions. Indicate whether you:
i) strongly agree, ii) agree, iii) neither agree nor disagree, iv) disagree, or v) strongly disagree with the following statement.
- High returns are more important to me than protecting the value of my portfolio.
- I consider myself to be a conservative investor.
- I want to maximize my returns even if that means sometimes I will see the value of my portfolio decline.
- I expect that my portfolios will only contain high-quality companies.
- I am willing to include speculative investments in my portfolio.
- I would want my portfolio to include a high proportion of high-quality bonds.
The responses would then be averaged out to put you somewhere along the spectrum between very conservative at one end and very aggressive at the other end. For more on the Likert scale, check here.
This is another important area to consider especially if you are going the self-managed route. Would you be comfortable adding an options’ strategy for example to a stock portfolio to either hedge downside risks or to extract extra income
Flexibility and risk capacity
Flexibility is necessary for any long term financial plan. Circumstances are going to change. A professional financial adviser will check in with their clients at regular intervals. Investors doing it themselves will need to build in their own periodic reassessments and make course changes as needed. The capacity to adjust your portfolio to changing needs and circumstances is also an aspect of risk management.
Portfolio risk strategy
If the period over which you are building capital is long then you will start with a greater proportion of higher risk and reward assets than during the payout phase. But also during the payout phase part of your expenditures could be highly discretionary and other parts would be essential. You would want the essential expenditures to be covered by stable income sources while discretionary spending could be funded through more speculative income sources.
Pulling it together
I hope you found this article interesting and useful. Do leave me a comment, a question, an opinion or a suggestion and I will reply soonest. And if you are inclined to do me a favor, scroll down a bit and click on one of the social media buttons and share it with your friends. They may just thank you for it.
Disclaimer: I am not a financial professional. All the information on this website and in this article is for information purposes only and should not be taken as investment advice, good or bad.
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