One of the first things we do with Revo Financial clients, after we discuss your goals and values, is assess your risk tolerance. There’s a reason for that: All investing involves risk. (But so does not investing.)
Since any financial plan involves risk, it’s important to understand the many complex factors that determine the riskiness of your portfolio and whether that risk is appropriate.
What is risk?
Risk means exposure to danger. In financial planning and investing, we focus on one very specific danger: losing money.
We face that danger, or take on that risk, because potential rewards (or returns) live on the other side of it. Investing may grow your assets. This is the essence of the risk-reward tradeoff, wherein greater risk is tied to larger rewards.
As an example, consider corporate bonds issued by companies with low credit ratings. That rating means analysts think the company is at a higher risk of default than its peers. The company will likely pay a higher coupon rate on any bonds it issues to make the risk worth it for investors.
That’s just one example. There are numerous types of risk to consider.
Types of risk
Let’s start with the example we just mentioned: default risk.
Default risk refers to the possibility that a bond issuer will default on interest payments or fail to repay the principal at maturity. Companies that issue high-yield bonds are compensating you for taking on more default risk.
In fact, the main reason U.S. Treasuries are viewed as a relatively safe investment is because the U.S. government has never defaulted on its debt.
Business risk refers to the risk that comes with investing in a single company. A company defaulting is one form of business risk, declining share prices on that company’s stock are another. Any time you invest in a single entity, you take on the risk that the company could falter or even fail. Many things can impact the health of a company, and not all of these factors are easily predictable.
The risk that a single business will fail is an example of nonsystemic risk—a risk that can be isolated from the broader market (or system). For instance, if a single company declares bankruptcy, it usually doesn’t impact the entire stock (or bond) market.
When a very large company faces turmoil, however, or when multiple companies experience a crisis simultaneously, you might hear experts talk about contagion; they’re worried the event will trigger systemic risk.
Systemic risk refers to the risk that comes with investing in financial markets overall because there’s a risk that the entire system could falter. The events that led up to and contributed to the 2008 Financial Crisis are a good example of systemic risk.
This can also be referred to as market risk since it applies to anyone invested in the market. You may hear people talk about stock market risk or bond market risk, and the systemic risk included in those. This is the broadest type of investment risk.
Interest rate risk is related to inflation and inflation risk. When rates increase (usually to combat inflation) the value of existing bonds falls—if you wanted to sell those bonds on the secondary market, you’d need to do so at a discount, since they pay a lower interest rate than newer bonds. Falling bond prices can lead to a net loss on the investment.
Liquidity risk refers to how accessible an investment is. For instance, property tends to carry significant liquidity risk since accessing the cash value of the investment requires time and effort. This is somewhat related to opportunity risk, otherwise known as opportunity cost: Every time you make an investment in something, you give up the opportunity to use that money for something else. So items with high liquidity risk may also carry opportunity risk; when your money is tied up in one investment, it can’t be used for new investments.
Geopolitical risk refers to how global and political events impact asset prices. For example, when terrorists attack or we see war in the Middle East, it can impact the cost of oil and defense stocks, as well as the health of companies with significant operations in the region. Beyond wars, contested elections, regime change, and natural disasters can all trigger geopolitical risk, to name just a few.
How risky are you?
Any investment portfolio includes exposure to all or some of these risks. At Revo Financial, we try to assess how much risk our clients want to take on and how much risk they can comfortably handle. The first is referred to as risk appetite, the second as risk tolerance.
Let’s use a nonfinance example.
Say Kate wants to climb Mount Everest. She reads books about mountaineering and starts imagining her adventure. But as Kate starts to prepare, she realizes she doesn’t enjoy the camping portion of long hikes. She also realizes she’ll need to miss her cousin’s wedding to complete the trek. And even with all the work and sacrifice, she isn’t guaranteed to summit, or even survive the trek. In the end, she decides Everest isn’t worth it and decides to climb Machu Picchu instead.
In this example, Kate started out with a large appetite for risk, but her risk tolerance wasn’t as high. She had other priorities, like time with family, that were more important to her.
As financial advisors, our job is to understand not just your appetite for risk, but your tolerance for it. While you may crave huge investment returns, that kind of risk may not be practical based on your lifestyle and goals.
Measuring risk tolerance
When we look at clients’ risk tolerance, one of the first things we look at is time horizon. Investors with a longer time horizon can generally afford to take on more risk. All investments fluctuate, but in general, the stock market averages positive returns over longer time periods. The longer you stay invested, the higher the chances that your investments will recover from any losses.
We also look at how much money you have to invest. If you don’t have money that you’d be OK losing, your risk tolerance is likely to be lower. If you have the resources, we might suggest you set aside a small portion of your portfolio for higher-risk investments. This calculated risk could boost your portfolio returns if high-risk assets do well but won’t derail your nest egg if the assets lose all value.
Finally, we use your goals to help us better understand how you need your portfolio to work for you. If you’re hoping to use invested capital to help with a down payment in five years, while simultaneously saving for retirement, we’d assess your risk differently than if you were focused on retirement alone.
By now, we hope you understand why we focus on risk when building financial plans with our clients and the different types of risk we consider when building client portfolios. If you have questions about the specifics, don’t hesitate to contact us.
