The higher the market climbs, the more concerned we become. This phrase is injected into nearly every meeting we have with clients. Why? Many reasons, but for the purposes of this article it is because the time to concern yourself with the risk in your portfolio, counterintuitively, is when the markets seem the most positive. Risk can be defined, in short, as the distance between the highs and lows a portfolio is likely to experience over time. Portfolios with higher risk have substantially higher highs and lower lows than portfolios with lower risk. So, it stands to reason, when your portfolio is experiencing a season of highs, the lows are more likely to be just around the corner. When evaluating your risk, we consider three risk scores: risk capacity, risk tolerance, and portfolio risk.
Risk capacity is the amount of volatility a portfolio can withstand given an investor’s financial goals, needs, and circumstances. The portfolio risk capacity of an investor who is younger, still working, and adding to their portfolio each year is, in many cases, higher than one who is retired and living off the interest in their portfolio. Risk capacity is largely determined by objective criteria, not psychology.
Risk tolerance can be defined as a client’s comfortability with highs and lows in their portfolio. This varies widely from one person to another. It is largely subjective, but equally as important when determining portfolio risk. Investors who have high incomes, substantial assets, and many years remaining before retirement can still have extremely risk averse temperaments. The converse can be true as well.
These two factors help determine an investor’s portfolio structure, or risk, when planning for their financial goals. In some cases, a client’s goals may be derailed because of a portfolio structured contrary to their risk capacity and risk tolerance. Regular assessment of these variables is a part of our preparation for all client meetings. This is especially true in seasons when markets seem to be doing quite well.
- Eric Puckett
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