In last month’s article, we explored the relationship between financial planning and investment management, and how any investment necessitates a well-defined financial plan to determine the investment time horizon. This time horizon dictates the ability to take risks, and this month we will talk about a saver’s willingness to take risks.
A person’s willingness to take risks is a personality trait just as much as agreeableness or openness. Although education and knowledge can demystify risky investments, a person’s willingness to take risks is deeply personal and often difficult to change. All people land on a spectrum from totally risk averse to totally risk seeking. Taking the time to determine where you land on this spectrum will help you build a portfolio that you can live with and will avoid unnecessary anxiety and sleepless nights in the future.
How do you know where you land on the willingness-to-take-risk spectrum? Some questions to ask yourself, what would you do and how would you feel if you woke up one day and your account value was cut in half due to a market crash? What would you do and how would you feel if the market was up 20% in a year and you were only up 11%? Given the choice between a sure $100 or the chance to win $0 or $250 in a coin flip, which do you choose? What if it were a sure $100 or the chance to win $0 or $195 in a coin flip? When you hear the word “risk”, what other words come to mind?
As a fiduciary, I would never recommend taking more risks than your time horizon would allow. However, if you are a more risk-averse person, then it makes sense to dial back your risk lower than what your time horizon would allow. The other thing to keep in mind is that if you do not have a lot of experience investing, you may be more risk-averse than you think if you’ve only experienced a bull market or more risk-seeking than you realize if you’ve only experienced a bear market. Given the multidimensional factors that determine a person’s willingness to take risks, it always helps to have an independent, unbiased, and experienced investment professional evaluate both your ability and willingness to take risks before making any investment.
Tune in next month when we talk about the foundation of every financial plan, the Safety Net!
In Sinatra’s classic pseudo-limerick, “Love and Marriage” he sings, “Love and marriage, Love and Marriage, Go together like a horse and carriage. This I tell you, brother, you can't have one without the other.” Maybe you can in 2023, but you definitely cannot have a sound investment strategy without a solid financial plan.
When choosing investments, savvy investors evaluate both their willingness AND ability to take risks. While an investor’s willingness to take risks is as much a personality trait as introversion and extroversion, an investor’s ability to take risks is a cold, calculated function of the expected time horizon for the investment. For example, is the investment meant to fund a child’s college education expense that starts in 3 years, or is it meant to grow wealth to fund a retirement that’s 20+ years away? Maybe it’s a mix of both short- and long-term goals, where you are deep in retirement, taking large RMDs from your IRA to fund your living expenses, but also investing a portion of the account to fund RMDs that are 10 years away. No matter what, prudent investors define their investment horizon before investing as part of a solid financial plan.
Why is this important? Some investors may have enjoyed years of double-digit returns in the stock market through 2021, only to be disappointed that their account was down 20% in 2022, right when they needed the money for tuition, the RMD, or to fund their life after being laid off. A fiduciary financial advisor can help clients avoid these major pitfalls.
Similarly, all solid financial plans involve some form of investment, no matter how risk-tolerant or risk-averse the client is. Piling money under the mattress or sheltering it in bank accounts has never been a winning long-term strategy.
Sinatra said it best, “Try, try, try to separate them, it's an illusion. Try, try, try and you will only come to this conclusion….You can’t have one without the other!”
Tune in next month when we’ll talk more about an investor’s willingness to take risks!