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Investment Risk Tolerance


10 Personal Financial Planning Steps in the Right Direction

This is one of the “10 Steps in the Right Direction” that make up The Pasadena Financial Planner‘s personal financial planning and personal investment management process. For a summary of these ten steps, see “Your Family Financial Planning“. To find an in depth article for each step, just click the Sitemap link at the top of this page. Also, you can reach us by using the contact form below. Please enjoy reading this article. Thank you!

Individual investors with different levels of investment risk tolerance for financial risks tend to be more satisfied with risk management strategies, which are better aligned with their financial risk and return profile.

Individual investors differ in their personal preferences related to risk management in their personal investment portfolios. This means that more risk-averse investors are personally more satisfied with a less risky investment portfolio – despite the fact that the expected returns of a lower risk portfolio may be substantially less. In contrast, investors who are less risk-averse tend to be more satisfied with portfolios characterized by both higher risk exposure and higher expected stock market returns.

Everyone would love both low investment risk and high investment returns in the same portfolio, but such portfolios are just pipe dreams. Investing is all about intelligent and sensible exposure to investment risks. If you are not exposed to the risk of losing some or all of your capital, you are not investing. Nevertheless, there are market investment risks that historically have paid an investment risk premium, and there are many other ways to take risks without a reasonable expectation of being compensated for those risks.

When defining a personal investment strategy and before making related decisions, it is important for individuals to assess their personal risk tolerances relative to other investors. The challenge is to gauge risk tolerance relative to others and then to adopt an investment strategy that reflects that relative risk tolerance.

Investing involves risk, and there is no way around it. Investing means that the investor is willing to incur risk in exchange for the possibility of a higher payoff. An investor’s relative risk tolerance is the primary decision in his asset allocation strategy.

You are not investing, unless there is a chance that you will lose some or all of your capital investment. Rational investors expect increased returns for taking on investment risks.

True investors are all assumed to be risk-averse versus risk-seeking. Market prices of securities reflect the market’s current risk consensus. Investors have rational expectations for positive risk-adjusted payoffs. Investing is not like traditional gambling, where the expected average payoff is negative.

On average, stock and bond investments have paid investment risk premiums historically. These premiums have fluctuated and have been thoroughly unpredictable. Investors who have consistently stayed in the market have earned higher returns over time. While the desire to avoid investment risk is understandable, investment studies have demonstrated that efforts to time the market by jumping in and out have not been successful.

Everyone would like higher returns, but only some are able and willing to live with the greater risks that are associated with a potential for higher returns. However, there are no guarantees in investing.

Investors with different levels of risk tolerance are more satisfied by the expectations associated with investment strategies that are better aligned with their risk preferences. Differences in risk tolerances mean that more risk-averse investors are personally more satisfied with a lower risk portfolio despite its lower expected returns. Less risk-averse investors are more satisfied with portfolios characterized by higher risk and higher expected returns.

All apparent investment “guarantees” have a price and have risks. Because investing is inherently risky, individuals should understand their probable response to risk factors that actually do materialize. Risk tolerance is an issue of personal psychology and will determine whether an investor will adhere to and sustain an investment strategy during more difficult economic and investing times. When markets are performing poorly and fears are high, an inappropriate alignment between an individual investor’s portfolio risk or volatility and his or her risk tolerance can be very costly.

In such circumstances, some less knowledgeable and unprepared investors may take actions, which may be appropriate to their personal psychology at the time. However, these mistaken actions can be highly inappropriate for the current financial market situation and highly detrimental to their long-term financial goals and welfare.

For example, some investors may panic and sell when they did not have to, only to see the market recover later, while they remain on the sidelines with a dramatically diminished financial asset portfolio. Portfolios with different risk and return characteristics are simply better for certain investors depending upon their tolerance for risky investments.

While there are a variety of approaches to the measuring personal investment risk and return preferences, brief and overly simple written surveys often are not sufficient.

Individuals need to assess their emotional and behavioral tolerance for risk relative to the average person holding investment assets. This self-assessment process is not easy. Individuals need to reflect upon personal real-life financial and other situations from their past lives, which involved significant risks and rewards.

Individuals often are reasonably good judges of their likely behavior in the face of stock market risks and other financial market risks that might actually materialize. However, these same individuals often are not good at assessing the likelihood of risks occurring. A truly competent and objective financial adviser and investment counselor can aid in this process.

The asset allocation of the average investor’s portfolio serves as a baseline for average investment risk tolerance. The challenge is to determine your risk tolerance relative to such an average investor, and then to adjust your asset allocation accordingly.

An investor would not wish to be talked into an overly aggressive and uncomfortable investment strategy that would be difficult to sustain through difficult times. Conversely, an investor would not wish to adopt an overly conservative strategy. Conservatism may feel more comfortable, but it tends to require much higher rates of personal savings to build up needed investment assets across a lifetime.

If you would like to find our about how you can take an online investment risk tolerance analysis survey, click here: Investment Risk Tolerance Questionnaire

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Pasadena Investment Adviser

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Larry Russell, Managing Director

MBA – Stanford University, MA – Brandeis University, and BS – M.I.T.

Lawrence Russell and Company Pasadena, California 91103

(626) 399-9579

A California Registered Investment Adviser — Certificate 133101

KNOWLEDGE — OBJECTIVITY — HONESTY — DILIGENCE — SATISFACTION

A truly independent financial planner and fee only investment advisor

(Concerning my compensation, I charge only on a fixed fee or hourly fee for service basis, and only under a contract agreed upon with you. I do not charge any asset fees. Furthermore, in the interest of avoiding all conflicts-of-interest, I do not accept compensation or commissions of any type from the financial industry.)

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