How to Invest and Then Still Sleep at Night

Everyone has their own level of risk tolerance or risk appetite, which represents the uncertainty they feel comfortable taking when investing. But do they know their own personal level of risk comfort? Most people are unlikely to understand their true risk appetite until they are facing a serious potential loss; until they are staring at a monster decline, they cannot know whether they have the stomach for it. It is easy to assume that everyone has high risk tolerance in a bull market as their portfolios keep heading upward!

Individual risk capacity
First, it is useful to distinguish subjective risk tolerance — an acceptable degree of "financial pain" — from risk capacity, an objective term that describes a person's overall individual financial situation and resources. Financial planners analyze several factors to arrive at an appropriate score. These should be reevaluated as their clients approach retirement.

• Time horizon: Within a longer framework, an investor can assume higher risk, with the expectation that the months and years will smooth out the volatile bumps.
• Goals: Income and future plans, such as home ownership or retirement, dictate whether an investor can afford to take on a given risk at a certain time. It helps to separate these investments into buckets.
• Age: Younger investors can enjoy a longer path ahead to navigate market ups and downs.
• Portfolio size: Having more assets acts as a cushion. The larger a portfolio, the smaller the percentage a loss reflects.
• Comfort and stress: Everyone has a different breaking point and psychological attitude when it comes to loss. Studies show most people experience more distress from losing money than pleasure from acquiring it.

Investors and their planners must try to align the parameters of risk capacity with risk tolerance. The dilemma is that, in many cases, investors have a low risk tolerance and a high capacity for risk, or the converse. For instance, some investors are ready to embrace much riskier investments than their assets or prospects would indicate. Or those who have started saving late for retirement may need to take on more risk than they would ideally like to.

Creating profiles
Financial planners use a set of typical profiles to characterize their clients according to suitable types of investments. These groupings provide a framework for discussions.

At the most cautious end of the spectrum, conservative investors gravitate toward preservation of capital as an overarching goal. They generally look for interest-bearing securities, such as treasuries or blue-chip corporate bonds, with perhaps a sprinkling of growth stocks.

Next on the continuum, moderate risk investors, with a slightly longer perspective, seek a similar mix, with something like a 70/30 defensive/growth ratio.

Then come balanced portfolios, looking at about a five-year time period. These often divide assets 50/50 between growth, such as equities and listed real estate, and more defensive positions, including cash and fixed income.

Lastly, the most aggressive investors shift closer to all-equities holdings, looking out as far as nine or 10 years.

Quizzes and questionnaires
Planners use tools to try to elicit clients' risk appetites and to help them understand how their own attitudes are guiding their choices. Quizzes pose a slew of questions, such as:

• In how many years do you intend to start making withdrawals, and for how long?
• Which is most important to you, protection or returns?
• Do you expect your income to grow, decrease or stay stable?

Unfortunately, many of these questionnaires are poorly designed and neglect important topics such as longevity and inflation risk. They fail to link risk to specific objectives and focus too narrowly on clients' risk appetites as an initial screen rather than a thorough examination of goals.
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Keeping these limitations in mind, start a conversation with your financial adviser to develop a fuller understanding of how your risk tolerance may be impacting your investment decisions.