By Bradi Dahmen of CNC Financial Group, LLC
What is your ability to withstand short-term losses?
This question is at the core of any discussion about risk tolerance. Some people are able to ride through turbulence in financial markets with a shrug while others suffer from heartburn with every bump. Many investment professionals recommend that their clients adopt an investment policy statement (IPS) to address risk tolerance in terms of long-range goals and desired returns.
What life factors shape your risk tolerance?
Two factors come quickly to mind: your age and your time horizon.
As you age, you have fewer years to recoup market losses. Gradually reducing the amount of risk in your portfolio over time is logical. Many financial professionals advocate this type of planning, and Wall Street firms have even created investments around this premise.
Your timeline to retirement also influences your risk tolerance. If you are certain that you will start tapping into your retirement savings in 2021, your appetite for risk may pale compared to someone whose retirement may start sometime in the 2030s. Broadly speaking, your time horizon for any financial goal directly affects your risk tolerance in investing toward it.
What market factors influence your risk tolerance?
Four market factors stand out – the most obvious of which is market risk. All securities carry the uncertainty of earning their expected rate of return. This volatility can be measured in a variety of ways based on historical performance. (You could argue that history means nothing with regard to an investment’s future performance, and that argument is legitimate – but lacking clairvoyance, we study history to give context for our future expectations.) The impact of market risk can be magnified when a portfolio lacks diversification. Having more eggs in more baskets can help insulate (though not entirely protect) against declining markets.
Liquidity risk can emerge significantly, especially as you age. Sometimes retirees will invest in certain financial vehicles and realize later (with frustration) that those dollars are “locked up” and cannot be accessed readily – in other words, the investment is illiquid. If they want their money back, they’ll have to pay a penalty. Taking on liquidity risk may be more than a retirement-aged investor can handle.
Marketability risk is the cousin of liquidity risk. It isn’t a measure of liquidity, but of tradability. If you can sell an investment quickly, its marketability risk is lower. If you can’t, its marketability risk is higher. Some people can’t tolerate investments that they can’t get in and out of.
Finally, we have inflation risk: the risk of your purchasing power lessening over time. When you invest in such a way that you can’t keep up with inflation, you lose ground economically. Suppose yearly inflation increases to 3% today. That means that a year from now, you will need $103 to buy what you bought for $100 a year earlier. In ten years, you will actually need $134.39 rather than $130 to buy what you bought a decade back because of compound inflation. Its effect functions just like compound interest.1
Retirees with conservative portfolios overweighted with fixed-income investments provide a good example. In a world where equities outperform fixed-income investments, retirees’ returns would have been a fraction of equity returns. In addition to the opportunity cost they are currently paying, they risk struggling economically if the pace of inflation quickly accelerates.
What kinds of risks do you feel comfortable assuming?
This is the big-picture question, the question for today and tomorrow. A discussion with a financial professional may help you confidently determine your answer.
By Bradi Dahmen of CNC Financial Group, LLC
CNC Financial Group, LLC is housed in the accounting Firm of Cordell, Neher & Company, PLLC
Bradi Dahmen may be reached at (509) 888-0430 or firstname.lastname@example.org
Securities offered through 1st Global Capital Corp., Member FINRA/SIPC. Investment advisory services offered through 1st Global Advisors, Inc.
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
1 – inflationdata.com/articles/2013/02/05/impact-inflation-savings/ [2/5/13]