We all instinctively approach most decision making as a simple process of calculating risk and reward. Depending on what is at stake, we weigh the possible benefits of a given scenario working out perfectly against the consequences possible if all goes awry, and then estimate the probability of each of these outcomes before deciding how to proceed. The choices we make in any such situation depend not only on these factors, tied directly to the matter we are considering, but also on our own personal tolerance for risk in general. When the stakes are low, typically risk-averse persons may be more willing to throw caution to the wind; when the stakes are higher, even the daredevils among us are more likely to take a step back and consider more conservative choices.
When it comes to building a diversified investment portfolio and making a long-term financial plan for retirement, the individual choices that must be made – both initially and on an ongoing basis – carry enough weight that their inherent potential for risk or reward must be considered carefully. As such, these are the types of decisions that should be made with the benefit of as much information as possible, which is why financial advisors spend such a great deal of time learning about and evaluating potential investments. Even with all of this data in hand, however, there may still be a crucial data set missing – the current and anticipated risk tolerance levels of investors themselves. At BFA Wealth Management, we view this information as critical to creating a properly balanced portfolio for each individual we serve, and we provide all of our clients with a thorough risk management assessment in order to help them understand their true tolerance for investment risk.
Creating investment portfolios that are both unique to each investor as well as diversified in the interest of risk management involves more than just market knowledge. It is a process that begins, first and foremost, with an understanding of each investor’s true tolerance for investment risk, which we discover through a customized assessment tool designed to measure investors’ reactions to a number of scenarios of varying complexity, all set against the backdrop of their real-life finances and retirement goals. Going through this assessment allows us to generate a risk tolerance score for each of our clients; this number represents the investor’s willingness to accept potential risk of loss in the face of potential monetary gains. Using this key insight, we are able to design investment portfolios and retirement strategies unique to each individual we serve, diversified among many asset classes and individual assets as well as balanced to reflect the investor’s true risk tolerance.
While this process is instrumental in starting each individual on a journey they are comfortable with, many factors can – and often do – change over time. Market conditions fluctuate, life circumstances change, expenses crop up unexpectedly, and individuals’ comfort level with investment risk can shift as these and other extraneous influences change the nature of one’s financial environment. That’s why we consider continuous assessment of our clients’ risk tolerances a necessary element of proper and timely portfolio rebalancing. An individual’s tolerance for risk may be higher earlier in their career, for example, but may diminish as they near retirement and grow closer to achieving the goals they set when beginning the process of planning their financial lives.
To help all of our clients feel comfortable with their investments, we feel that we must do more than simply rebalance portfolios over time in order to keep them in line with the initial risk scores we employed in their preliminary design. We must also measure our clients’ risk tolerance at key milestones in their plans, after they achieve goals, ahead of and following major expenses, and at other important points in our relationships. This allows us to constantly work toward aligning our clients’ investments with their real lives - and their true tolerance for risk along the way.
By allocating appropriate percentages of each portfolio to assets with varying risk profiles, we can create an overall portfolio in line with an investor’s risk tolerance – rather than attempting to only invest in assets that individually carry a level of risk approximately in line with the investor’s tolerance for the same. The result is a mix of more conservative and more aggressive investment assets essentially carrying an average level of risk which, when taken as a whole, is appropriate for the portfolio’s owner.
Both in our initial portfolio designs and at any point at which a client’s circumstances change, as well as when portfolio rebalancing is prudent, we use our clients’ risk tolerances to inform us as we focus on asset allocation to create a diversified portfolio. Asset allocation is the process of dividing the whole of an investment portfolio among various types of financial assets, the three typical examples of asset classes being stocks, bonds, and cash.
Asset classes alone are not specific enough for us to build a truly customized portfolio; we drill down to specific asset subclasses – and further, to individual assets – in building a diversified portfolio for each of our clients. Subclasses define assets with more clarity; assets within a subclass will share more in common with one another than they would with assets in a different subclass of the same primary asset class. For example, domestic stocks are often broken into subclasses based on market cap; large-cap stocks are typically issued by companies with market capitalization above $10 billion, mid-cap stocks by corporations with market caps between $2 and $10 billion, and small-cap stocks by firms with market caps below the $2 billion mark. Other examples of asset subclasses include:
- Real estate investment trusts, or REITs - which you can learn more about here
- International securities – assets issued by foreign corporations and traded on foreign exchanges
- Money market securities – debt securities with maturities of less than one year, such as Treasury bills; T-bills and other money market securities are often considered a subclass of cash assets due to their high liquidity
- Emerging market securities – shares traded in the markets of developing economies
- Fixed-income securities – debt securities offering a fixed amount of interest (either at maturity or periodically until maturity), such as government-issued bonds
For an investor with a risk tolerance score on the aggressive end of the spectrum, asset subclasses that offer higher potential for returns may be attractive despite their higher level of risk; assets such as international securities, which often fit this profile, can offer such investors exposure to potential short-term gains in keeping with their more aggressive risk tolerance. However, to keep the portfolio of an investor such as this diversified, more conservative investments can be made in order to offer the potential for stability. Assets such as Treasury bills may be appropriate in this scenario, as they trade high potential for gains in value for lower risk of loss. Overall, our goal in constructing a balanced, diversified portfolio for the hypothetical investor here would be aligning an appropriate mix of assets with the investor’s tolerance for risk at the time.
The key to maintaining investment portfolios that are in keeping with the long-term financial plans of our clients is benchmarking each investor’s risk tolerance at the beginning of our relationship, then revisiting this critical measurement as needed. While rebalancing portfolios when prudent does allow us the flexibility to maintain the balance of risk and reward we initially set out to create, this process only accounts for changes in assets – not investors. As our clients progress through their financial plans, we routinely adapt to their anticipated needs through risk tolerance evaluation. For example, if a client’s planned major expense such as a wedding is fast approaching, it may be appropriate to revisit the client’s portfolio balance in light of the impending cash outlay. For some investors, this may seem like a good time to invest more aggressively in order to pursue higher potential gains; the prospect of offsetting a cash expense with investment gains may make perfect sense to such an individual. Someone else, however, may see this as a time to shift their investment strategy to a more conservative one, attempting to limit risk of loss in light of the known significant expense in their future. The disparity in outlook on risk versus reward between these two hypothetical investors highlights the importance of tailoring each investor’s portfolio strategy to their real lives, allowing for adaptation based on changes in markets, assets, and above all, the evolving needs, circumstances, and opinions of the clients we serve.
If you would like to learn more about financial planning and portfolio diversification based on your own true tolerance for risk, or if you are interested in getting a second opinion on the plan you have already set in motion, BFA Wealth Management would be happy to offer you a complimentary investment analysis and risk management assessment to help you understand your options. Contact us today to learn more about planning your financial future on your terms or to schedule your complimentary, zero-obligation investment analysis. Let’s talk.