By Barbara O’Neill, Ph.D., CFP®, [email protected]
Risk tolerance is an investor’s capacity to handle the uncertainty that accompanies the selection of specific investment products such as stocks and bonds. For example, bonds are subject to interest rate risk (where bond prices fall as interest rates rise and vice versa), and stocks are subject to market risk (where general stock market trends affect the performance of individual securities). Risk tolerance has also been referred to as the “sleep at night factor,” as in “how much investment risk can you withstand and still be able to sleep at night?”
Many Personal Financial Managers (PFMs) discuss investment risk tolerance in briefings and counseling sessions with service members. This often occurs in discussions about Thrift Savings Plan (TSP) investments and asset allocation percentages. Below are three categories of investors and mindsets that describe them:
- I want my money safe at all times, and I don’t want to lose any of it.
- Any decline in the value of an investment that I own concerns me.
- I’m uncomfortable with price volatility (i.e., changes in investment share prices).
- I want to minimize losses and fluctuations in the value of my investments.
- I like to invest in something safe that offers a fixed rate of return.
- I am willing to give up higher rates of return in order to keep most of my principal intact.
- I prefer investments that provide regular income without much exposure to principal loss.
- I want my investment return to beat inflation by at least 2 percent.
- I select investments that have a moderate amount of volatility, yet offer the opportunity for rates of return higher than certificates of deposit or government bonds.
- Although a decline in the value of my investments concerns me, I can accept temporary market volatility in return for growth opportunities.
- I would like to increase the value of my investments moderately, with limited exposure to risk, and I am willing to ride out market downturns.
- I want a balanced investment mix and am willing to put up with some short-term fluctuation in value.
- I like substantial appreciation opportunities, even though it puts my capital at high risk.
- Temporary market fluctuations do not concern me because appreciation is my primary long-term goal.
- I expect a return greater than the S&P 500 (large U.S. company stock index) from my investments.
- I am financially able to accept some limited liquidity in my investment portfolio.
- I take calculated risks in order to ensure a potential for the highest return over time.
- I can hold on to investments during those years when they could drop in value by 25 percent or more.
It is important for service members to know that there is no such thing as a “risk-free” investment. All savings and investment products have some type of risk. Even the most conservative investments such as money market funds have purchasing power risk, which occurs when investment returns fail to outpace inflation.
To help investors objectively assess their investment risk tolerance, the University of Missouri has a free online tool, the Investment Risk Tolerance Assessment (IRTA). PFMs may wish to use this tool with clients.
Developed by two university professors, Dr. Ruth Lytton, and Dr. John Grable, the IRTA consists of 13 multiple-choice questions and provides users with feedback about their perceived capacity to handle investment risk. The questions are based on users’ thoughts about risk in hypothetical situations and their current investing behavior. Aggregate answers to IRTA questions are used in research studies about investment risk tolerance.
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