Risk Tolerance & Investing
I’d like to share with you a story about two people, Mary and Susan, who are both 43 years old. Last year, Mary’s financial advisor helped her earn an 8% return on investment, while Susan’s portfolio only netted a 4% return over the same period. Mary whistled through the hallways at work bragging about her gains, while Susan went home frustrated with her advisor’s mediocre performance. Two weeks later, Susan switched advisors. Two months after that, Mary’s portfolio lost 10% of its value.
Mary and Susan aren’t real, but they serve to illustrate an important point about why comparing investment returns is usually meaningless. There are the four main reasons why.
For starters, not everyone has the same risk tolerance. That is, how much of a decrease in asset value can you stomach without feeling nauseous? A person’s appetite for risk is not just determined by personality. Their situation matters too. For example, a single person in their 20’s with consistent income may have a higher risk tolerance than a middle-aged father who is closer to retirement and has a family to support.
Risk tolerance is an important factor in how people invest. The size of your return is usually commensurate with risk. The bigger the risk, the bigger the reward—or potential loss.
Investors will a low tolerance for risk will be drawn to safer instruments that come with smaller returns. Treasury bonds, for example, are a nearly risk-free investment. Yet the yield is so low, there’s a chance your investment may not even keep up with inflation.
All else being equal, results can vary widely between two people with different risk tolerance. It’s impossible to tell from someone’s age, demographic, or even financial situation what their tolerance is, and how it will affect their investment strategy.
When it comes to investing, circumstance matters, and that includes investment horizon. That is, how far is the investor from retirement? Generally speaking, younger investors can tolerate more risk than someone older because they have more time to ride out the volatility of the market.
Another aspect to consider is an individual’s goals. Not everyone strives to accumulate the biggest pile of money they can. Some people may want to live off their investment income, and therefore prioritize a smaller but steady stream of return. Mary may have instructed her advisor to pursue an aggressive growth strategy for her account, which would explain the 8% gain one year, and 10% loss the next.
Finally, keep in mind that investments are only one component of an advisor’s value in planning for retirement. When it comes to big life decisions, such as buying a house, managing the death of a loved one, or estate planning for our own demise, most of us look to an advisor for expertise and guidance. An advisor’s greatest value is not stock picking, but helping you determine your unique goals and make thoughtful choices to meet them.
So the next time you meet a Mary who is bragging about her impressive returns, you’ll have a little more perspective—and feel better than Susan did.