Discovering your true risk tolerance level

By David Joy, Chief Market Strategist, Ameriprise Financial

Key Points

  • Identifying your risk tolerance level is critical to developing an appropriate investment portfolio.
  • Yet, traditional methods of determining your appetite for risk can fall short.
  • Ameriprise Financial is developing an approach that can help you more precisely assess your risk tolerance.

The ability to accurately identify an individual’s risk tolerance is one of the foundational underpinnings of a well-designed investment portfolio.

Typically, the process involves answering a series of questions related to your financial position, investment goals and attitudes toward maintaining a consistent portfolio — even through periods of significant market fluctuations.

The objective of such a questionnaire is to reveal where you reside on the risk spectrum, ranging from conservative to aggressive. Defining your risk tolerance level makes it possible to build a portfolio that is suitable for your needs.

 

Not a perfect science

There are limitations to the process of determining an investor’s risk tolerance. It is rather mechanical, designed to be “one size fits all,” at least as a first step. Furthermore, research shows that various factors, such as your degree of financial literacy, educational background, marital status and other variables can influence how you respond to a risk-tolerance questionnaire.

In addition, your answers are subject to change over time. “Recency bias,” for example, can influence how you respond to questions about your ability to manage market risk. From an investment standpoint, this means your answers at a time of relative market calm may not be the same as your answers at a time of real market stress.

For example, it wasn’t unusual to see investors turn far more risk-averse after the dramatic stock market decline of 2007 to 2009. Today, into the 11th year of a bull market, you may be more inclined to shift to a more aggressive investment stance and take on more risk. But will the next bear market change your perspective again?

 

The need for an honest self-assessment

Ancient Greek philosophers exhorted their students to “know thyself.” Investors should do the same. Develop an understanding of your hopes and fears, motivations and aspirations, and how those factors might impact your attitude toward gain and loss, risk and reward. This is one of the foundational principles of behavioral economics, which reminds us that we are human, not the rational actors that classical economic models assume.

A number of factors influence the decisions we make about our financial lives. Understanding how you are likely to respond to changing market conditions makes you better equipped to avoid counter-productive, emotionally driven short-term decisions. By honestly assessing your risk tolerance level, you are less likely to abandon a thoughtful investment plan during a market selloff, or to take on excessive risk during a bull market. You should seek to build an investment portfolio that is designed to work for you over the long run, with only minor adjustments from time to time.

 

Your advisor can help

Ameriprise Financial is developing new tools to make the process of identifying your risk tolerance more dynamic. It uses a series of real, historical market scenarios to illustrate their impact on a portfolio, in both percentage and dollar terms. The process is designed to enhance the traditional risk-tolerance questionnaire by making it more interactive. You will gain a greater appreciation of how specific changes in future markets are likely to impact your own portfolio. In this way, we believe the process will lead to greater precision in defining what it means to be a conservative or aggressive investor, or somewhere in between.

As a result, you should be able to more clearly define where you, as an investor, truly stand on the risk spectrum. This is critical in the preparation of an Investment Policy Statement that documents your risk tolerance, investment objectives and the frequency with which to revisit and potentially make adjustments to your portfolio.

To learn more about risk tolerance and the role it plays in building a sound portfolio, or if you have questions about your own profile, please speak with your Ameriprise financial advisor.