Are You In Tune With Your Risk Tolerance These Days?

In the late 1990s, with the stock market on a record-setting run, investors were more than willing to talk about returns, but they didn’t always want to hear about risk. The market downdraft that followed changed all of everything, as risk reentered the investment vocabulary. Recognizing risk is a good first step, but are investors who are rethinking their strategies taking the next step and conducting a personal risk tolerance assessment?

Coming to Terms With Risk
Risk can be more difficult to discuss than return, and not just because it’s an unpleasant topic. The concept of risk is multidimensional, and depending on your goals and time frame, you may be able to tolerate some forms more than others. For example, how exposed is your portfolio to each of the following risks?

* Market risk, which has been so prominent recently, represents the possibility that the value of a portfolio will fall as a result of broad declines in stock prices.
* Inflation risk is at play when a portfolio doesn’t provide returns that outpace the rising cost of living.
* Shortfall risk is the chance that a chosen investment strategy won’t provide the return needed to achieve a particular goal.
* Interest rate risk might be described as a seesaw effect if interest rates rise, bond prices typically fall, and vice versa.

The better you understand these and other types of risk, the better prepared you may be to assess your overall risk tolerance.

Measuring Intangibles
Risk can also be difficult to discuss because an investor’s ability to tolerate it is not easily measured, like height or weight. It’s dependent on a host of individual, sometimes intangible factors, including emotional reactions and past experiences.

But the process of measuring risk tolerance has come a long way. Decades ago, it wasn’t uncommon to gauge risk tolerance by asking investors if they’d ever consider perilous activities, like hang gliding or mountain climbing. Today, surveys and questionnaires have been designed to help measure investors’ risk tolerance relative to other investors depending on the score achieved, for example, an investor might fall on the “risk averse” end of a scale, the “risk tolerant” end or somewhere in between. Risk tolerance tools are also being advanced through the use of psychometrics a field of study that incorporates psychology and statistics.

More important than the tools perhaps, is the input of an experienced professional who knows how to make the most of a risk tolerance assessment. Risk tolerance has to be compared with an investor’s risk requirement the level of risk that needs to be accepted in order to pursue a particular financial objective. An individual with limited risk tolerance and more aggressive goals, for example, may need assistance structuring a portfolio with the potential to bridge the gap.

If it’s time to review your risk tolerance a process that may be worth repeating annually consult your financial advisor. Together you can conduct a risk tolerance assessment and then crosscheck the results against your current portfolio.

©2004 Standard & Poor’s Financial Communications. All rights reserved.

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