Understanding Your Risk Tolerance: Aligning Emotions and Investment Strategy
Diversification is a powerful tool to help build investment portfolios that are equipped to weather the ups and downs of the markets. However, before your advisor can build a well-diversified portfolio, you must determine your unique risk tolerance. Understanding your risk tolerance means recognizing both emotional comfort and financial capacity for risk. Having risk tolerance well defined and ensuring that emotional comfort and financial capacity are both recognized allows investors to stay well-disciplined through market volatility.
What Does Risk Tolerance Really Mean?
There are two parts to defining your risk tolerance: emotional willingness to take risk, and financial capacity for risk.
Emotional Willingness to Take Risk
As an investor, your comfort with market volatility varies with your personality and experience. When markets shift up or down, emotional reactions often drive investment decisions more than data does. Allowing a financial advisor to manage your asset portfolio removes the emotional bias from decision making. When you clearly communicate your risk tolerance with your advisor, they are able to invest your assets in ways that align with your goals and beliefs.
Financial Capacity for Risk
Financial capacity is the objective ability to absorb losses while staying aligned with your long-term goals. When thinking about your financial capacity for risk it is important to consider the time horizon for each of your financial goals, as well as your income stability and cash flow needs, and your asset base and liquidity.
Financial capacity for risk can vary with your stage of life. For example, a retiree drawing income may have less risk capacity than a young investor who is still actively accumulating wealth.
How Advisors Assess Risk Tolerance
Being aware of what risk tolerance means for you is one thing, but applying it to your overall financial goals is another. Risk tolerance is not static; it is something that evolves as you experience different life changes. A financial advisor uses both quantitative tools and qualitative conversations to assess your changing risk tolerance and apply it to your investment portfolio. Allowing a financial professional to make investment decisions based on your unique risk tolerance can remove emotional bias from decision making. Your advisor is there for you through the major life changes – marriage, retirement, and career shifts – to help make sure your risk tolerance aligns with your short-term and long-term goals. It is important to connect with your advisor and review your risk tolerance regularly to keep your investment strategies aligned with current goals.
Align Your Portfolio with Your Tolerance
A financial professional can connect your unique risk tolerance directly to asset allocation decisions. This will help make sure your portfolio is properly diversified in order to manage volatility while pursuing growth. The right portfolio for your financial needs is one that supports your long-term goals and allows you, as the investor, to remain confident during market fluctuations.
Partner With Your Advisor
Your financial advisor will help interpret your risk tolerance and factor it into an actionable strategy. It is important that you continue the conversation with your advisor with regular check-ins. Your advisor is there for you to discuss market changes and adjust plans as your life changes, serving as a guide and a partner in maintaining discipline through market cycles.
Confidence Through Alignment
Successful investing requires aligning how you feel about risk with how your portfolio is structured. A financial advisor is there to help you through it all. It is important to regularly revisit your risk tolerance with your advisor regularly.
If you would like to review your current portfolio to determine if it still reflects your comfort with risk and your long-term goals, our team is happy to help!