Risky Business

How to Assess Your Tolerance to Market Volatility

Sean P. Lee

October 7, 2014

Following a year with as significant and surprising of market rally as 2013, it can be easy to lose sight of realistic expectations and goals for your investments. For every up there is a down, and understanding your personal risk tolerance, or how much volatility you are truly comfortable with, is critical for building an investment portfolio that is right for you. Risk tolerance can be difficult to measure as it varies widely from person to person and is constantly evolving with age, life circumstances and market fluctuations. The challenge is to know where you are at any given time and to make sure your portfolio is consistent.

A risk assessment is the process of ensuring your investments are not overexposed to loss through high-risk investing, costly penalties and fees, or uninformed or emotional decisions regarding your money. Assessing your own risk can help prevent your money from falling through the cracks, while maximizing profits and minimizing surprises from your investments. 

Most risk assessments require an investor to answer a series of questions that can help to ascertain long-term and short-term goals as well as risk attitudes. 

Long-term goals should identify your financial goals for five years or more into the future. Ask yourself the following questions:

What is your goal for this investment?

a)      To grow aggressively

b)      To grow significantly

c)      To grow moderately

d)      To grow with caution

e)      To avoid losing money

Assuming normal market conditions, what would you expect from this investment over time?

a)      To generally keep pace with the stock market

b)      To slightly trail the stock market, but make a good profit

c)      To trail the stock market, but make a moderate profit

d)      To have some stability, but make modest profits

e)      To have a high degree of stability, but make small profits

Short-term goals should show how you feel about short-term volatility in the market. Questions you should ask include:

Which of these statements would best describe your attitude about the next three years’ performance of this investment?

a)      I don’t mind if I lose money.

b)      I can tolerate a loss.

c)      I can tolerate a small loss.

d)      I’d have a hard time tolerating any losses.

e)      I need to see at least a little return.

Which of these statements would best describe your attitude about the next three months’ performance of this investment?

a)      Who cares? One calendar quarter means nothing.

b)      I wouldn’t worry about losses in that time frame.

c)      If I suffered a loss of greater than 10 percent, I’d get concerned.

d)      I can only tolerate small short-term losses.

e)      I’d have a hard time stomaching any losses.

Types of Investors

Based on your responses, you will primarily fall into one of five categories, ranging from conservative to aggressive.

Most conservative investors look for a consistent, inflation-adjusted income stream to pay their living expenses, primarily through dividends. This type of investor wants to maintain minimal market fluctuations and is willing to sacrifice a large portion of market growth potential to achieve this goal. They’re either currently depending on their investments to give them a retirement paycheck or are expecting this to happen soon.

A moderately conservative investor wants some consistent dividend income but also wants to experience some market growth in their portfolio. They can tolerate a little more risk than the conservative investor, but are still worried about the impact of the ups and downs of the market. The typical investor in this category is either retired or quickly approaching retirement, or is innately more protective of their money.

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