Reassessing your risk tolerance
The Sterling Report
THE reactions of investors to the recent volatility in the international capital markets have surprised many investment advisors. Investors with relatively high-risk appetites fled to "safer" investments, leaving many advisors to wonder if they really understood their clients or alternatively, if the risk tolerance of their clients was changing?
An investor's risk tolerance affects the types of investments he makes and the potential return he/she can earn. Your financial goals throughout the different stages in your life affect your risk tolerance. It is important to understand these connections while factoring in the constant changes in the financial markets.
This can be tricky because the goals you had last year may not be the same today. This is where your relationship with your financial advisor is important and heeding their advice as the relationship progresses. You need to review the changes in your goals and risk profiles periodically and adjust your portfolio accordingly. You probably already review your account statements on a regular basis to monitor its performance and any changes in the investment strategy. Investors should therefore take some extra time to review the risk profile of their investments and make prudent changes to balance their changing needs and expected returns.
Even the best risk tolerance questionnaires ask investors to identify the maximum loss of capital that they can absorb.
Advisors and investors should re-evaluate risk tolerance on an ongoing basis to obtain the most accurate reading. The constant reassessment of an investor's risk profile, especially following market changes will help to ensure that an investor's risk tolerance is consistent with his portfolio and that they are both aligned with his changing goals and objectives. The potential return on any investment made is linked to the investor's tolerance and objectives.
Most people identify risk management as the act of principal protection. While this is true to an extent, there are scenarios that this objective can be self-defeating. For example, locking your money away exposes it to inflation risk. What you perceive to be gained in stability will be lost in buying power.
Even complex readings of risk tolerance have limitations when assessing the appropriate level of risk for an investor. For example, risk tolerance does not measure whether the investor is financially able to take on risk. Nor does it consider how risky the investor perceives his or her investments to be. These important issues must be addressed by a competent financial advisor.
Despite these limitations, risk tolerance should not be dismissed. However, perceived risk, required risk and risk capacity are essential to fully understanding an investor's risk profile. There are many types of risks, which apply to different securities. The following are some of the types of risk you should keep in mind.
* Credit risk — the possibility that the issuer will not repay you. You may lose your invested capital or not receive expected interest payments.
* Liquidity risk — the risk that you will be unable to easily liquidate an asset (such as a piece of real estate, or a bond not trading) at any time
* Market risk — the possibility that an investment may lose its value (ie decline in price)
* Interest rate risk - the risk that, if interest rates rise, the price (value) of an investment will decline.
* Reinvestment risk — Describes the possibility that an investor will be unable to find an equally attractive investment once he sells his existing security.
By carefully assessing all the risks an investment offers and periodically reviewing the holdings in your portfolio with your financial advisor (in the context of your risk tolerance), you should be able to find a level of risk that is appropriate for meeting your changing investment goals.
Lisa Minto is manager, financial planning with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor.Contact: firstname.lastname@example.org or visit on Facebook and Twitter.