You say you can stomach any turmoil in the market. But when stocks are whipsawing, and your portfolio balance is dropping, what do you actually do?
That gap between what we think we can handle and what we actually do in the moment is at the heart of risk tolerance — and it is one of the most important variables in building a financial plan that works over the long run.
What Risk Tolerance Really Means
Risk tolerance is not simply a personality trait or a number on a form. At its core, it is an assessment of your emotions and your behavior when markets move against you. How do you feel when you see a significant decline in your portfolio? What is your first instinct?
For many people, that instinct is to sell. When liquidity drains from the market and dollar losses start to accumulate, the desire to stop the pain is entirely human. But acting on that instinct by abandoning a long-term investment plan in response to short-term volatility is generally not in your best interest.
Our job as investment managers is to stay disciplined and keep clients invested in line with their long-term asset allocation. A plan is only as good as the paper it is printed on if it is not actually followed. That is why understanding your true risk tolerance before volatility arrives matters so much.
How We Assess It
There is no perfect way to measure risk tolerance, and I want to be honest about that. The most common method is a risk tolerance questionnaire — a structured set of scenarios designed to gauge how you would respond to various market conditions. If the market is down and you see a substantial loss in your portfolio, what are you likely to do? Sell? Hold? Buy more?
The challenge is that questionnaires have real limitations. People can answer based on how they want to feel rather than how they actually behave. And the state of mind you are in when you complete the questionnaire matters enormously. During a bull market, most people feel more capable of taking risk. As retirement approaches and the transition from a steady paycheck to living off the portfolio becomes real, that tolerance often shifts in the other direction.
That is why risk tolerance assessment is not a one-time exercise. It is ongoing. Living with clients through different market environments gives us a much more accurate picture than any questionnaire alone. How a client reacts when things get difficult tells us far more than what they said they would do when things were calm.
How Risk Tolerance Shapes Your Portfolio
Risk tolerance is one of three primary inputs in how we build a client's asset allocation. The other two are age and the percentage of the portfolio being drawn down in retirement.
As clients get older and begin drawing on their portfolios to fund their lives, the ability to absorb risk naturally decreases. The amount being withdrawn matters too. A small, sustainable draw is very different from a withdrawal rate that could threaten the longevity of the principal.
Risk tolerance scores are then layered on top of that framework, putting people into categories — well below average, moderately below average, average, moderately above average, or well above average. This allows us to adjust the equity and bond targets accordingly. A client in their sixties drawing a meaningful portion of their living expenses from the portfolio, who also scores well below average on risk tolerance, would see their equity target adjusted down by roughly ten percentage points, with bonds increased by a corresponding amount. The reverse is equally true for clients with a higher tolerance.
Importantly, we try not to make asset allocation changes during periods of market stress. One of the most damaging things a client can do is sell out of a depressed portfolio, locking in losses at the worst possible moment. Adjustments based on updated risk tolerance assessments are best made during steadier, more normal market conditions.
The Goal: A Plan You Can Actually Follow
There may not be a perfect way to assess your tolerance for risk, but getting a handle on how much volatility is too much for you is one of the most valuable things you can do for your financial future. A portfolio calibrated to your actual risk tolerance — not your aspirational one — is a portfolio you are far more likely to stay invested in through the inevitable ups and downs of the market.
At Foster & Motley, we work with you to build a personalized plan that demonstrates what living your most meaningful life actually looks like in practice: not just the right allocation on paper, but the right allocation for you.
If you would like to talk through how risk tolerance fits into your own financial plan, reach out to our team at Foster & Motley.