Why Should You Take a Risk Tolerance Questionnaire?
We all have different comfort levels with so-called “risky” activities. Some of us live for the adrenaline rush that comes with bungee jumping or skydiving, while for others of us, watching an action flick on Netflix is about all the adventure we can stomach.
The same is true with investing. Everyone has a different tolerance for risk. Some investors can handle greater amounts of risk, while others prefer to be more cautious when it comes to taking risks with their money.
At Alpha Wealth Advisors, a vital part of our financial planning process is understanding our clients’ ability to tolerate the inherent risks of investing. Determining risk tolerance is critical to our ability to customize an investment strategy that meets our clients’ unique needs.
What is Risk Tolerance?
In short, risk tolerance is a measure of an investor’s willingness to accept higher risk or volatility in exchange for higher potential returns. Put another way; it is an investor’s ability to withstand a loss in their investment strategy.
When we talk about risk tolerance, we usually mean one of three types:
1. Aggressive: This type of investor is willing to use high-risk strategies to achieve potentially higher returns. Aggressive investors are generally able to withstand substantial market volatility and resulting fluctuations in account value.
2. Moderate: These investors believe in balancing portfolio risk through tried-and-true investment strategies such as asset allocation and diversification — a fancy way of saying they don’t put all of their eggs into one type of investment. Moderate investors are also apt to diversify their accounts by risk, mixing relatively low-risk options with higher-risk ones.
3. Conservative: Such investors are willing to accept lower returns in exchange for preserving the safety of their money. Their investment mix often includes so-called “safe” investments such as CDs, bonds, cash, and money market accounts.
While financial advisors typically classify risk tolerance based on one of these three categories, these are merely labels. They aren’t quantitative, and they mean different things to different people. Thus, one of the best ways to truly identify your unique risk tolerance is to take a quiz.
Take a Quiz
By taking a risk tolerance questionnaire or quiz, you’ll better be able to determine your ability to withstand a loss — not just financially, but emotionally. And, when it comes to risk tolerance and your investments, your emotional reaction is really what counts.
Curious about your risk tolerance? We offer a simple, free risk tolerance quiz on our website that reveals your investment style in about two minutes. You can have your spouse take the quiz, too, if you’re married. We’ll ask you about your current age and your anticipated retirement age. Then we’ll ask you a series of questions about how much you have invested and how much you could potentially stand to gain or lose depends on the potential risks and rewards.
For example, the quiz asks if you have $100,000 and you could gain $20,000 in six months, how much could you risk losing for this potential gain? The questionnaire is interactive, so you can easily dial up or dial down the risk to customize your tolerance and the losses you’re able to withstand to achieve a potential gain within a specified timeframe. We have found that those who are more risk-tolerant tend to score higher on the quiz, whereas investors who are more risk-averse tend to score lower.
To put some context around that, the overall market has a risk score of 72; cash has a score of zero. People tend to fall somewhere between zero and 72, but some may score higher.
That said, our clients’ quiz results simply serve as a starting point for our overall risk assessment. We can create a portfolio with customized asset allocation or investment mix, that uniquely reflects our clients’ risk tolerance. We don’t use a one-size-fits-all approach that puts clients into one of five asset allocations, for example. We take a more thoughtful approach that enables us to match our clients’ investment strategy as precisely as possible with their risk tolerance.
Does Risk Tolerance Change?
We get asked this a lot. So, should you ever re-take a risk tolerance quiz? Yes, there are specific times when it may make sense to revisit your risk tolerance, including:
• Lifestyle changes, such as a job loss, divorce or death of a spouse, or an unexpected windfall or inheritance.
• Economic or market changes, such as the recent volatility we have experienced due to the coronavirus pandemic sweeping the globe and the resulting health and economic crises.
When we’re just starting to work with new clients, we find it helpful to understand their risk tolerance from the beginning. By doing so, we can implement an investment strategy that makes sense for them. That’s why we advocate for taking the risk tolerance quiz — it gives us valuable insights to help us tailor your portfolio in a way that serves your best interests.
Our advisors always look out for clients’ interests by thoroughly vetting every fund we use in our investment portfolios. That entails extensive due diligence, including meetings with fund managers, pouring over risk/exposure reports, and ongoing monitoring and analysis of managers’ performance. And, if the manager doesn’t meet our performance expectations, we may consider terminating the manager and removing that fund from our strategy.
While investing can be fun and rewarding, it can also be risky. Like in skydiving, the consequences of not knowing what you’re doing can cost you dearly. So, it can be helpful to have someone, like a financial advisor, to guide you through the process.
Getting to know your risk tolerance is a significant first step, whether you’re new to investing or you’ve been at it a while, and you just need some extra support. Click here to take our complimentary risk tolerance quiz. It only takes a few minutes.
And remember, investing is only one part of a comprehensive financial plan. Give us a call if you have questions about your risk tolerance, how to build a portfolio, or any other personal finance matters. We’d be glad to have a conversation with you and see if we can help.