Feeling Risky? Considerations For Asset Allocation

The Roaring Fork Valley attracts risk takers with our range of type “A” personalities, outdoor enthusiasts and business entrepreneurs. In my early days here, I excitedly jumped over the edge of Walsh’s and kayaked Slaughterhouse in June without any thought to the risk I was taking, possible painful consequences or long-term effects of my endeavors. Now, I look at risk differently, especially in my vocational calling. In the world of setting life goals and handling money, how do you correctly assess and manage your market investment risk?

The industry standard for evaluating investment “risk tolerance” can range from a few short questions to several pages of inquiry around your financial and emotional ability to tolerate market fluctuations. With questions answered, a “suitability” is determined that incorporates your attitudes about risk, your time horizon, your need for income, along with other available assets and an investment portfolio is designed for implementation.

This is not a complete picture and should not be used as the only gauge for determining an investment strategy. The problem with the traditional approach is that it confuses someone’s capacity to take risk with their actual need or desire to do so.

To more accurately determine your “risk tolerance”, you need to quantify several aspects of your goals. True risk capacity is a measure of how risky your goals are. For example, does the goal you are working towards require a high rate of return just to have a chance of success, or does the goal have such a low risk that even a bad market can’t derail it.

The “suitability” needs to be a combination of the portfolio you are investing in and the goals that you are aiming to achieve. It is crucial to be certain that neither the portfolio, nor the goal is riskier than what you can actually tolerate.

Let’s look at two individuals – Sam Snowmass and Christy Carbondale. They each take the “traditional” questionnaire asking about their attitudes and willingness to take risk. Both are highly adverse to risk. The next step incorporates the “traditional” component of time horizon, income need and available assets. Sam and Christy have very different lives and financial situations.

Mr. Sam Snowmass would like to “rewire” in 15 years and would like an income stream of $50,000 a year from his investments to supplement income from other sources. With what he has accumulated so far and his continued savings, his portfolio is projected to grow to about $2,300,000. With the combination of his attitudes and willingness to take risk, his longer time horizon and available holdings, the traditional “suitability” analysis would put him into a “moderate growth portfolio”. If something went horribly wrong with the market, he has time to recover. (We have all heard that one!) His desired withdrawal rate is still extremely conservative and safe. However, this portfolio allocation is not appropriate for him. Sam doesn’t have a high capacity for risk. Just because he can afford to take risk, doesn’t mean he should or that he even needs to take it. With economic seasons, he WILL experience market corrections and he won’t be sleeping well at night with his “moderate growth” portfolio.

Christy Carbondale is “rewiring” this year and wants to start drawing from her portfolio immediately.  Above what she will be receiving from other resources, she wants $65,000 a year, rising with inflation, from her current $1,000,000 portfolio. Because she is currently taking income, short time frame and mental aversion to risk, Christy would traditionally be put into a very conservative all bond and cash portfolio. This won’t work for her either because of her goal to have a 6.5% distribution rate. Her goals are inconsistent with her risk tolerance. The real conversation with Christy is not about whether to take on more risk with her portfolio to create the income stream she wants, but around creating more realistic goals and lifestyle that align with her tolerance for risk.

A risk tolerance questionnaire is a great place to start, but a lousy place to stop. Dig deeper, qualify, prioritize, and quantify meaningful life goals. The optimal portfolio solution is the one that can best achieve your goals, constrained by risk tolerance to ensure that neither the portfolio, nor the goals, exceeds the clients

Share this episode