Like so much terminology in the financial industry, “risk tolerance” is a concept that is ambiguous and loosely defined. For investors, the concept of risk represents potential dollars lost between initial investment and the predetermined date when they plan to access the money.
This is their investment time horizon.
Building portfolios to match time horizons is an art, and financial planners can't design portfolios to target artificial, worst-case risk limits. An asset manager can develop an idea of an investor's tolerance for risk, but in the end, risk tolerance in investing is nebulous — investors often don’t know how much risk they can tolerate until they encounter market turbulence.
Risk Tolerance: Hypothetical and Inaccurate
The industry defines risk tolerance as the amount of money an investor is willing to lose. The problem, however, is that this is an artificial limit. In reality, market crashes determine the amount of risk an investor will assume, and in many cases, crashes force investors to assume more risk and tolerate more drawdown than they anticipated. There are eight reasons for this:
People are often made to believe there is nowhere to hide from a crash.
They are made to believe that if they hold their investments for the long term, eventually the market will recover and they will regain their losses.
The risk they face turns out to be greater than they anticipated.
They believe incorrectly that no one did better than they did.
They assume incorrectly that things will always improve.
Financial software provides incorrect calculations because it is programmed to work with average returns instead of compound returns.
Often, people’s time horizons shrink and they have less time to grow their money than they originally thought.
Portfolios are built for moderate risk in normal markets — and often for inflated-average growth — not extreme conditions.
The good news, however, is that sound tactics (movement or changes at the time risk is happening) may help investors avoid some of that risk, as discussed in Your Personal Period of Return™.
Risk as a Standard Deviation
Emergency room doctors ask patients to rank the level of pain they perceive with a 1-10 numerical value. The goal is to turn the subjective concept of pain into a standard deviation, which is an exact formula used to quantify how far something has varied from the norm.
What Loss Means to Investors—and How to Mitigate it
Investors don't think of risk as a standard deviation or a mathematical construct. Instead, they think of risk exactly as they should—purely in monetary terms in regard to the dollar amount they will lose if things go badly.
When it comes to managing risk, stops can be put in place to attempt to serve as a tourniquet. For example, under the right conditions, a drawdown to $800,000 on a $1 million investment would trigger a full withdrawal to avoid further loss.
They key is to pay close attention to what market history is indicating, as there can be several indicators that suggest a crash or correction is imminent. Knowing these indicators can help investors understand when a crash or correction is more likely to occur. With this in mind, it is never a good idea to base a strategy on how much an investor guesses he or she is willing to lose.
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