Thanks for coming back for the latest edition of Planning for your Purpose, Telos Financial’s blog where I discuss different financial planning topics. Dennis LaVoy is a CERTIFIED FINANCIAL PLANNER™ professional (CFP®) and a Chartered Life Underwriter (CLU®) and is Ann Arbor’s financial advisor serving clients around southeast Michigan and across the country. The purpose of the blog is to introduce financial planning concepts and questions I receive from clients that I believe are important. I want to start discussions about that will educate, benefit, and improve your financial life. Ultimately, to help you focus on your telos!
What is risk tolerance?
Risk tolerance is the way the financial advising industry tries to quantify how best to align investments for a client. There is not a simple one size fits all investment and it’s not enough to just pick something. There are of course, a lot of rules of thumb out there and you can pick those, but if you dig deeper, you can probably get a better suited investment portfolio for your situation with some work. As a financial advisor, my job is to get to know my clients, understand their goals, discuss pros and cons with them, and ultimately agree upon an appropriate risk level for them.
Why do I need to know my risk tolerance?
There are several benefits to understanding your risk tolerance. First, it will help you make sure your investments are allocated so you have a higher likelihood of achieving your goals. Let’s say you are 25 years old and are saving for retirement when you are 65 years old. You have a long time frame in this case with your retirement savings, so from a timing view, you can take more risk on because you’ll have more time for the investments to recover if they fell before you need to access them.
Next, it gives you realistic expectations. If you found online some stocks that you thought would do well and bought one or two, you may end up very well off or you may end up with nothing. Analyzing your risk tolerance and aligning your investments with it gives you better understanding of the downside you might experience. It helps to make sure you’re taking enough risk to achieve your goals (based on your assumptions) and the benefits and potential travesty involved with that risk.
For example, let’s look back at a mid cap stock index performance for a recent ten year period from 2009 to 2018. $10,000 invested in the index would be worth $24,943 today or a return of 249%. However, that same fund had a decline of over 42% at one point during those ten years. If you chose this investment only looking at the potential returns, but needed the funds when it was down 42%, you’d be in trouble. Time frame is really important.
Similarly, if you had purchased a ten year treasury bond ten years ago, you’d have earned just over 37% percent during that same period. While interest rate movement causes the price to fluctuate over time, if you had a ten year time frame and no intention to sell, you were sure your principal would be there at the end of the time period.
What if I don’t have goals?
You gotta have goals. Not really, but it certainly makes things easier. Maybe you just don’t know when the goals will come to fruition. Most people want to retire at some point, maybe it’s 55, maybe its 70. If you’re 30, it probably doesn’t make a huge difference between these two because a 25 year time frame versus a 40 year time frame sort of apples to apples. Both are long term in the investment world, so would be similar. The more specific the goals, the easier it is to identify the timeframe, but general ideas help to narrow it down as well.
Soft goals are also helpful. Maybe you want to pay off your student loans, buy a house, retire early, pay for college for your kids, pay for your wedding & honeymoon, and take a vacation every year; but are single, living with your parents, and just graduating college. These could be many years away with no way to attach a timeframe, at a minimum, having these ideas and knowing they may change, gives you something to aim for. You can make adjustments year to year and as things develop, but it gives you a target today.
It’s also important to understand that you can have multiple risk tolerances. Let’s say you’re 43 with a 18 year old child and you’ll be paying for some of their college and you want to retire at age 70 because you love your job. You should probably have the college savings account allocated much more conservatively than the retirement account. Your child is probably going to college in the next few months, but retirement is over 25 year away. Just looking at the timeframe gives you much more room for volatility in the retirement account versus the savings that need to be available in less than a year.
Bottom Line
What’s the point? The point is a lot of investment decisions you make should be guided by your goals. Time frame, your sleep factor, cash flows, other assets, and anything related to your financial life needs to be taken into consideration. Risk tolerance is very specific to every individual, it will probably change over time, and a family will most likely have multiple risk tolerances for multiple accounts.
Telos Financial is a Michigan’s financial advisor for Millennials, Xennials, Generation Xers, & young professionals. It is a financial planner for the Detroit area, is fee based, & a holistic financial planning firm located in Plymouth, Michigan serving young professionals and families. Dennis LaVoy, CFP®, CLU® founded Telos and uses his experience, knowledge, and expertise to help families and individuals by providing financial advice in Ann Arbor, Detroit, surrounding areas, and across the country achieve their financial objectives.
Material discussed herewith is meant for general illustration and/or informational purposes only, please note that individual situations may vary. Indices are unmanaged and investors are not able to invest directly in any index. Past performance is no guarantee of future results. Investing involves risk including potential loss of premium. In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity date may be subject to a substantial gain or loss.
The views expressed are my own opinions and do not apply to every situation. Your situation may vary so make sure to consult a professional for advice prior to making any decisions.