The Importance of Knowing Your Risk Tolerance

It is interesting to learn of perceptions when it comes to investing. To some, investing may be keeping assets in a bank CD or money market account. To others, it may entail day trading and hoping to “beat the market.”

In reality both approaches may not be the best approach for investors who wish to minimize risk or maximize return.

The CD investor has maximum safety (low risk) but severely limited potential for any return given CDs are yielding 1% to 2%. The day trader is maximizing risk exposure with the hope of maximizing return, but at the same time potentially maximizing loss.

Investing is a personal matter and some may begin as soon as earned income is received and for others after all liabilities are met and there is excess cash. Prior to investing the concept of an emergency fund should be given serious consideration. The importance of saving three to six months (or more) of known expenses may be considered investing in yourself given the advent of an event prevents you from earning income or an unknown event necessitates spending non-budgeted expenditures. It is your safety net! Once your safety net is in place the beginning of an investing plan may start.

Investors do not usually plan to fail, but without a plan to succeed investing may become daunting, overwhelming and discouraging. Mistakes may be made and hard-earned income can become lost easily. Often investors blame the economy, market or cosmic source as the reason why they potentially have unsuccessful results. That isn’t to say investors may also ride the wave of a hot stock market or the luck of selecting an unknown stock which becomes the next superstar.

The point is you, as an investor, need to make the decision of your risk tolerance. An investor who likes CDs may not consider emerging markets any more than a day trader would consider a bond fund.

In reality, there exists hundreds if not thousands of potential assets to select from and invest. The best known are large, medium and small cap, emerging market, international, all with specialized subsets, S&P and other index funds, ETFs, etc. If investing in mutual funds, then it is important the fund manager adheres to the prospectus and the stated percentage of assets included in the fund. If not, fund drift may occur over time and the asset allocation percentages change within the fund and often without the knowledge of the investor.

Deciding to invest in any asset class has an inherent risk-return component. Generally funds with higher risk may presume to offer greater returns, but at the same time may present with higher loss. This concept is known as standard deviation appearing as a bell curve with risk-return falling to the right (gain) or left (loss) of a central point.

The concept of diversification is an important and pragmatic approach to investing. The idea of keeping all your eggs in one basket may appear prudent, but what if you drop the basket? Instead, the addition of other ingredients allows for a flavor unique to the investor and one’s risk tolerance. If you drop this basket, some eggs may break but other items may well remain intact.

Investing within one specific asset class may only allow for vertical diversification. All companies within this asset class are essentially similar and diversification within this asset class becomes near impossible, as it remains homogenous. True diversification involves more than one asset class with the goal of developing a portfolio of i.e., eight to 12 different asset classes or more yielding a horizontal diversification. The combination of different asset classes allows for an interesting blend to develop because of different correlation coefficients the assets have to each other. This allows for greater diversification, lower risk and potential higher returns.

Investing, asset allocation, fund tracking, standard deviation, risk-reward, etc., may be seen as daunting and it may well be even to a seasoned investor. The importance of consulting and working with a financial advisor (i.e., Certified Financial Planner or CFP) knowledgeable in asset classes and corresponding correlation coefficients may help make sense of the overwhelming amount of information.

Above all and most importantly, knowing and respecting your personal risk tolerance by ensuring greater potential returns while minimizing the corresponding risk.

H. William Wolfson, DC, FICC, MS, MPAS is a financial consultant and advisor. After passing the rigorous Certified Financial Planner examination, Dr. Wolfson obtained a Master of Science in Personal Financial Planning from the College for Financial Planning. He was subsequently awarded by the College a Master Planner Advanced Studies. Dr. Wolfson is a member of the Financial Planning Association (FPA). Dr. Wolfson retired after 27 years of active practice and remains active volunteering his expertise to the continued education and success of professional colleagues and investors. Dr. Wolfson may be contacted at drhwwolfson@gmail.com.