When I meet with a client to discuss their financial plan – whether we’re developing a “new” plan or having an annual review – an important part of the conversation centers around the investment plan and risk tolerance. How are their financial resources going to be invested to meet their wants, needs, and wishes for the future? And sometimes, that “future” is very near!
In order to get to that place, we talk about the three different types of risk that need to be considered:
- What is your risk tolerance? Refers to how comfortable someone is generally with taking a chance. Are you wired more conservatively or more aggressively or somewhere in between? Will stock market downturns keep you up at night with worry, or do you see it as an opportunity to buy more? Life experience can cause this to shift over time. We use an advanced questionnaire to help identify your personal tolerance.
- What is your risk capacity? Refers to your ability to “weather an economic storm”. Quite simply, have you accumulated enough assets so that your most important financial needs can still be met, even if you were to lose a portion of your portfolio? If so, taking some additional risk for growth opportunities may make sense.
- And finally, what is your financial plan’s risk target? Refers to the amount of risk that is likely necessary to achieve a given long-term rate of investment return. It may be a familiar mantra that risk and return are related. Your future financial goals might necessitate taking on more risk in order to achieve a potentially higher growth rate (return), in order to make up for a shortfall of savings. The alternative may be to modify your goals so that a conservative investment strategy can be successful for you.
Once all three types are understood, investment recommendations fall into place naturally. This “risky” conversation can be thought-provoking, and sometimes emotional. AND, it’s critical to developing a long-term investment strategy that won’t be abandoned at the first sensational market headline but instead truly works for you!