Broker Check

Risky Business – The Importance of Understanding Your Risk Tolerance

| January 09, 2019
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While many people choose to invest their money, you won’t find identical investment strategies or portfolios. If no two people are the same, their financial strategies shouldn’t be, either. When creating your investment portfolio, it is important to consider not only the different types of investments you would like to pursue, but also how risky they are – and how comfortable you are with taking those risks. By understanding your comfort level with investments, we can work together to create an effective plan that is personalized to you.

To identify your personal risk tolerance, it’s important to understand the different types of risk investors can face.

Different Types of Risk

There are numerous types of investment risk for personal portfolios. Because of this, each needs to be considered at every stage of your investing journey. Among the most common risks:

  • Market risk is the risk of investments declining due to economic developments or changes that affect the entire market. When you invest in stocks, there is a risk that the market price of your shares could fall. When you invest in bonds, there is a risk that the value of your bonds could drop due to changing interest rates.
  • Liquidity risk is the possibility that you will be unable to get the price you want for your investments when you choose to sell them.
  • Concentration risk occurs when your money is concentrated in one type of investment, rather than diversified across a wide portfolio.
  • Credit risk applies to bonds, and is defined as the possibility that the bond issuer will not be able to repay the interest and principal at maturity.
  • Reinvestment risk is the risk of losing money when you reinvest a bond’s principal or income at a lower interest rate.
  • Inflation risk is the possibility that the value of your investments do not keep pace with inflation, therefore reducing your purchasing power over time.
  • Horizon risk is the risk that your investment timeline may be shortened due to an unforeseen event, such as the loss of a job or a medical issue.
  • Longevity risk is the risk of outliving your savings.
  • Foreign investment risk is the risk of loss when investing in foreign countries.

In addition to risks related to the investing, it’s also important to consider the risk of unexpected circumstances, including you dying or becoming disabled, and how that will affect your investments and your family’s financial situation.

While navigating risks can be challenging, a financial planner can help you determine all of the risks associated with your unique portfolio and will create a plan that mitigates risk while keeping your goals in mind.

Time and Risk

There are a few different schools of thought when it comes to how time influences risk. Generally, however, the risk that you would sell at a loss goes down the longer you hold a well-diversified investment portfolio that generates a positive, long-term rate of return. Over time, the accumulated unrealized and realized gains will likely be greater than the typical fluctuations in market price. This does assume that you can choose when to sell and that you won't be forced into a sale (e.g. due to an emergency) when the portfolio shows an unrealized loss due to market fluctuations. At any point in time, the market risk is still the same, but you are less and less likely to face an unrealized loss on the portfolio the longer you hold it.

How to Determine Your Individual Risk Tolerance

To determine your risk tolerance, the Pinnacle Financial Advisors team asks each client to complete a risk tolerance questionnaire. This assessment includes questions about the types of investments you hold, when you want to retire, and how you would react to certain situations, such as the following:

From an original investment of $10,000, your portfolio, now worth $20,000 suddenly declines $3,000, or 15 percent. Which best describes your response?

  • I would look for a way to invest more
  • I would take no action
  • I would be somewhat concerned
  • I would avoid any investment that could suddenly lose 15 percent of its value

Based on the answers you provide in the questionnaire, our team creates a custom plan that is mindful of both your financial goals and your risk tolerance. Each person is comfortable with a different level of risk, which means our financial plans are truly custom.   

Additional Considerations

In addition to risk considerations, it is important to consider the difference between investments that receive daily valuations and investments that are only valued upon sale. Most people are used to thinking about investments that are traded on the stock or bond markets. Every day, we know their value and how much we could sell them for. However, you may own investments that are not traded on the stock or bond markets and for which daily values are not available.

Examples include certain mutual funds, REITs (Real Estate Investment Trusts), and BDCs (Business Development Corporations). Often, these kinds of investments cannot be liquidated at will. The regular statements you receive for such investments typically show a fixed value based on the original amount invested or a recent appraisal. They may give a false sense of safety, since there is no apparent volatility, or risk. However, you won't know their true value until you sell them, or they have a liquidity event, which is an opportunity to cash out some or all of your ownership shares.

Additionally, it is a fool's errand to buy investments when prices are high and sell when they are low, but we are all subject to the urge to do so. When prices are high, we feel really good about our investments and want to buy more. When prices are low, we are down in the dumps and feel like selling what we have to “get out of the market.” While you may have a gut feeling that it is the right choice, doing so increases your risk of losing money. A financial planner can talk through such situations with you, providing insight and recommendations for how to proceed for your unique life circumstances.

Contact us to learn more about Pinnacle Financial Advisors’ financial planning and wealth management services.

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