Risk Tolerance

Any time someone says they want to start investing or saving for the future, the first thing a professional asks them is “what’s your risk tolerance?”

This is the WRONG QUESTION to base decisions on.

There is a tendency to talk about “risk tolerance” as a feeling, or a sense that people innately have as a part of their personality. Retirement Planning & Employee Benefits by Dalton & Dalton defines risk tolerance as “the willingness and ability to accept risk for potential returns,” which can be assessed by questionnaires regarding the client’s “experience with risky assets and with the time horizon of the investment goal.” Basically, they’re asking “how much do you freak out when you lose money?” As though your emotional response to that “loss” should dictate your financial planning.

I don’t think that is an appropriate way to judge risk tolerance at all. Risk tolerance isn’t a feeling, it’s a mathematical equation. You must understand what amount of money you need in a number of situations. 

I find that a handful of important factors really play into one’s risk tolerance:

  • How much does your life cost?
  • Who is depending on you?
  • How secure is your job?
  • What non-financial resources do you have in the event of a disaster?
  • How much do you have saved? If it’s not much, you’re not alone.

The important thing here is to identify “what will you do if x happens?”

If you lost your job, do you have other people in your home that earn an income? Could you take your child out of childcare to save money? Do you have an awesome professional network that would allow you to get another good job quickly? Or are people depending on you for food and shelter? Are you in a lot of debt? If you have no savings, do you have another plan to earn money quickly? A side-job, or can you pick up something like DoorDash or Uber? What will you do about health insurance?

All these questions come into play when you are deciding how much money to save, and where to save it. When you are considering whether to put money in the stock market, you must ask yourself if you plan to use it. If you think you’ll pull from your 401k for a home down payment, or any other reason, then yes, you should invest more conservatively, trading lower risk for lower growth.

If you ran through that list and your resources are pretty light, that can be daunting. You know what, though? It’s probably not your fault. A large portion of Millennials’ perceived risk aversion stems from large financial liabilities, stagnating or even falling wages, and dwindling resources.

According to an article from CNBC, the cost of college has increased by more than 25% in the last 10 years, while the wages for recent college grads have been declining since 2000 according to the Economic Policy Institute (EPI) study on Wage Stagnation. This implies that these college grads are not only being paid less than reported wages were when they chose to pursue their degree, and that their increased liability allows them less take-home pay to actually work with. This calls for a larger liquid emergency fund that an individual could rely on to protect their financial status in the event of job loss or other emergencies.

At the same time, out-of-pocket healthcare expenditures have grown steadily since 1970 according to the Health System Tracker provided by KFF, and the percentage of both high school and college graduates who have access to employer-provided health insurance has been declining since at least 1988, also according to EPI . This, too, would indicate a need for a larger emergency fund or more expensive health insurance. While many seek to self-employ for income, it is recognized that a large amount of risk comes from a lack of job security and an increased healthcare cost as well.

On top of all of that, according to MarketWatch, even with interest rates at record lows, listing prices are10.6% higher than a year ago, a spike above the 25-year national average of approximately 3.8% per year, almost the same as you’ll be paying in interest, should you be unable to purchase a home in cash. Side note, Buying a primary residence is not a “good financial investment” EVEN IF you plan to sell it. Buy a home because you want one. Not as an investment. But that’s a different post (I’ll link it when I finish writing it!).  Millennials have struggled to get into the housing market more than previous generations for all of the same reasons that they struggle to focus on their retirement portfolios.

You are not “too risk averse,” as though you have some kind of inferior personality.  We are simply dealing with a higher risk, lower-resource period in the United States.  All these risks lead to a higher need for easily accessible cash and credit in the event of an emergency. One cannot really begin to aggressively invest for their future until they are taken care of today.

34 thoughts on “Risk Tolerance”

  2. erotik

    Have you ever thought about writing an e-book or guest authoring on other websites? I have a blog based upon on the same information you discuss and would love to have you share some stories/information. I know my visitors would value your work. If you are even remotely interested, feel free to send me an e-mail. Jacki Zacharias Garibald

  6. erotik

    Not a way around it that I know of. I think it would be fine for soups but other dishes not so much. Use the highest setting. The lowest one is like warm. Vickie Franny Brita

  9. erotik

    You need to take part in a contest for one of the most useful sites on the net. I am going to highly recommend this web site! Rebecca Damon Ot

  10. erotik

    You made some good points there. I looked on the net for more info about the issue and found most individuals will go along with your views on this website. Margret Demott Eisele

    1. admin

      Interesting, I haven’t heard this opinion on “risk tolerance” from anyone else so far in the personal financial planning field. I honestly hope it is more common though, as it definitely seems like an important issue to me.

  12. turkce

    You should be a part of a contest for one of the best sites on the internet. I am going to highly recommend this web site! Babita Skip Puiia

    1. admin

      This post is my personal opinion that “risk tolerance” should not be used as a decision factor based on portfolio allocation. It’s based on what I’ve learned in my family financial planning degree and experience in the field. Thanks 🙂

  17. erotik

    Great site. Lots of useful information here. I am sending it to a few pals ans also sharing in delicious. And certainly, thank you on your sweat! Janeczka Benn Ferren

Comments are closed.