Understanding Risk

 JOSH MUDSE, CFP

JOSH MUDSE, CFP

In the context of your investment portfolio, how do you define risk? For new investors, the answer usually involves the potential to lose everything, equating investing to some form of a casino game. Even though it is theoretically possible to lose all of the value in a portfolio, using the basic investing technique of diversification greatly reduces the possibility that your entire investment portfolio will drop to a zero value. For more seasoned investors, the definition of risk begins to form around volatility, or the range that their portfolio moves both to the upside during market growth, and to the downside during contractions. Market events such as “Brexit”, the tech bubble bursting and the Great Recession of 2008/09 provide opportunities to re-evaluate the risk in our portfolio. 

Traditionally, investment managers start and end the discussion about risk with some form of a Risk Tolerance Questionnaire, designed to quantify the amount of volatility that the investor is willing to accept in pursuit of long term growth. The results of that profile determine the long range asset allocation and the manager proceeds to invest your portfolio. Risk Tolerance is what I call your stomach number; how much downside portfolio volatility you can endure before your stomach attempts a double-back somersault. It is at those moments when good decision making is abandoned and many investors bail on their long term investment strategy. We think this simplified approach to risk leaves out a very important factor – Risk Required.

Risk Required is a calculation for how much market risk you need to take, or how much volatility you may need to assume in order for your portfolio to provide for your desired outcomes. Especially applicable to risk-averse investors, a portfolio that is designed from the start to underperform inflation can actually add risk to the portfolio, reducing your spending power over time. Determining the Risk Required for your situation is part of a comprehensive financial plan. We prefer to create an investment strategy within the context of your complete financial situation, including:

  • Identifying the cash flow you are going to need to support your desired outcomes
  • The timing of cash inflows and outflows
  • How you plan on paying for medical expenses including long term care 
  • What you want to leave behind in your estate for family and charity
  • What type of accounts you own (taxable brokerage, deferred IRAs, annuities, stock options, etc.) 
  • Your current and expected future tax situation

Because all investments carry some form of risk, managing risk involves more than planning for market volatility. Investors can help manage the risk of missing long term desired outcomes with comprehensive financial planning, which includes a portfolio constructed with a reasoned asset allocation. While no asset allocation is guaranteed to produce any specific rate of return, the allocation that best fits your situation is a combination of your Risk Tolerance and your Risk Required.     1323AVZ