One of the most widely discussed, yet poorly understood concepts in financial planning is “risk tolerance.” Investopedia defines risk tolerance as “the degree of variability in investment return that an individual is willing to withstand”. That sounds reasonable, but the amount of risk one is “willing to withstand” is abstract until it is tested in actual market conditions.

A few years ago, Natixis Global Asset Management published a study on the risk and return expectations of individual investors. The study had a couple of eye-popping revelations. First, the investors surveyed said they “needed” an annual return of 9.8% per year above inflation to reach their goals. Inflation averaged about 4% per year over the past 50 years, so that puts the nominal annual return “needed” at nearly 14% per year!! To make matters worse, 56% of those surveyed said that they were willing to accept only minimal risk to achieve the returns. These investors, (and many more just like them), have wildly out of balance return expectations and risk tolerances.

One concept mentioned in the Natixis Study  provides a good starting place for developing a realistic attitude towards risk; That is, investors said they “needed” a certain return in order to meet their future living costs. Indeed, risk should be calibrated towards goals. We counsel clients to be willing to accept the level of risk needed, but nothing more. What you “need”, based on your investment capital and living costs assumptions is the first step. If this works out to be well in excess of the historic returns for the stock market…well, a course correction is required (you may need to save more, work longer or change lifestyle).

Like most financial planning firms, over the years we have used a variety of risk tolerance questionnaires. We have never been satisfied that any of these did a good job of actually measuring tolerance for risk. For the main, they focus on psychological comfort and no one is really all that “comfortable” with risk. Risk tolerance is very personal and should be directly tied to your goals and expectations. If you are like the investors in the Natixis Study that “need” 14% annual returns, but only can tolerate minimal risk…your risk tolerance is way out of balance and your goals likely won’t be achieved.

Brain science tells us that part of the problem with the concept of risk resides in the way we make projections about our future . We plan rationally and project for the future as if we will always be in a “cold” rational state. The prefrontal cortex is the part of the brain most actively engaged when making these future plans. The problem is, life isn’t linear; life is dynamic and “things go bump in the night”. When we eventually experience financial loss, we use the parts of the brain most associated with emotion, the amygdala and other components of the limbic system. The differing brain systems make it difficult to model exactly how someone will respond to the stress of loss.

Risk tolerance should be much more goals based than age based. Your goals are more specific than “growth and income” or “moderate” or “conservative” or any of the descriptors used in the typical risk questionnaires. Risk tolerance is mostly based on your expectations for returns in the future. How these expectations differ from the reality of investing in the capital markets provide the real test. A good exercise is to become educated about normal variability in the financial markets so that you don’t panic.

We sometimes use the term “dispassionate discipline” to describe how we help clients who are thinking emotionally. We try to inject a measure of rationality into what can sometimes be a highly charged emotional thought process. This discipline, along with an overlay of a written financial plan, can provide the time and space needed to make smart choices. Ready for a real conversation?

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