Be Prepared: Know Your Appetite for Risk
“Emotions are the most important determinant of long-horizon wealth.”
– C. Thomas Howard, PhD.
Is there truth to Dr. Howard’s unorthodox statement that you need to know about? When you invest, you make choices. One of the main trade-offs is the level of risk you are willing to bear to achieve your stated investment goals. Too often, though, it’s presented as a ‘check the box’ decision but is it so simple?
There’s increasing academic research into personal financial risk tolerance as a vital aspect of developing a suitable risk profile. There is no ‘right’ or ‘wrong’ amount of risk – it is a decision which has to be tailored to you. The level of risk you can live with goes way beyond the typical factors like age, time horizon, investment objectives, and financial situation. It’s more about how easily you tolerate the inevitable swings in the market.
It turns out that risk tolerance is a personality trait; it’s about how you feel rather than how you think and, therefore, is quite stable over time, according to the folks at FinaMetrica, a leading provider of risk assessment tools. Our moods, on the other hand, reflect our current state of mind, tend to be transitory, and often readily subject to outside influences (aka media experts!). Therefore, our perception of investment risks can change in an instant. That’s where the trouble lies.
Investing outside your comfort zone is a story of personal misery. Why? Because how you behave in a ‘perceived’ market crisis may be fundamentally different from your rationale self and lead to actions that crystallize losses by selling at the wrong time.
Market volatility is neither risk nor your enemy. You might be disappointed about short-term performance but should never be surprised. The surest way to keep your head when others may not is to be prepared. Your financial knowledge, previous investor experience, and level of trust in your adviser act as counter-weights to help maintain the integrity of your portfolio in all market conditions. We help our clients conquer their all-too-human emotions because we are passionate about long-horizon wealth.
Most clients accept that it is necessary to take some risk to have the best possible chance of achieving longer-term investment goals. When developing your overall investment approach it is vital that you have a clear rationale for making investments and understand your capacity to withstand losses. Therefore the aim is not to avoid risk but to strike the right balance between risk and reward while meeting your investment objectives.