Risk Tolerance in the Bull Market Era

SMART INSIGHTS FROM PROFESSIONAL ADVISERS

Risk Tolerance in the Bull Market Era

Assessing your ability to take a chance on stocks is more important now than ever, and to get an accurate appraisal, a chat is much more effective than a questionnaire.

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The current bull market, which started in March 2009, is the longest in history. I frequently get asked about how long it will last and how big of a drop we can expect when the tide turns the other way. Unfortunately, no one knows the answer, and in fact, that’s not the right question to ask.

SEE ALSO: 5 Strategies for Managing Your Changing Risk Tolerance

Instead, you should be asking, "Am I invested where I'm supposed to be?"

This question is important, because it can help determine the true impact to your portfolio when the market falls again. The answer to the question lies in several other questions relating to your risk tolerance.

Risk tolerance is the extent to which you are willing to accept a greater risk of loss in a portfolio in order to potentially receive a higher return on those assets. I don't believe that a risk tolerance questionnaire is an adequate measure of how a person truly feels about risk. I always ask a client, would you answer a questionnaire for risk tolerance on March 9, 2009, when the bear market reversed course, the same way you would have in October of 2007, just before the 2008 crash? Of course, the answer is always no.

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After a massive market decline, few people feel they have the same risk tolerance as they did when stocks were hot. For this reason, a questionnaire lacks accuracy.

Instead, the answers to the following broader questions about you and your personal goals will give you a much better perspective.

1. What is your time horizon?

This is by far the most important component to look at first. It took five years from the crash in 2008 until the market reached a record high. When looking at your investments, you should ask yourself, "Do you need this money in fewer than five years? More than 10?" Sometimes when I'm asked about market drops, it's from people in their 30s regarding their retirement accounts. Those folks have a longer time horizon to potentially recoup their losses.

Contrast that with a retiree who may be living on the earnings from the investment account, and you have two very different answers to the risk tolerance question. If you have more than 10-15 years until you need the money, it's hard to make the argument to invest conservatively, unless you simply can't sleep at night knowing it can fluctuate. Part of the time horizon conversation includes your life expectancy. As planners, we tend to assume longer life expectancies because it is considered more conservative to do so. Often however, a person or couple in poor health might be unrealistic in assuming a 30-year time horizon.

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2. Can you sleep at night?

As mentioned above, can you sleep at night if you know your account could drop 30% to 40% in the next 12 months? You can have all the time horizon in the world, but if you'll be stressed out every waking moment then it will certainly factor into your overall risk tolerance. I often give new clients a scenario of a 40% drop in account value by our next annual meeting. I ask how they will feel about seeing that and discussing its impacts to determine their risk tolerance.

3. Do you have various other investments and income sources?

What other investments and income sources do you currently have? Do you receive a pension and Social Security? Does your spouse? If your fixed monthly income already covers all of your expenses, then you theoretically have a higher risk tolerance than someone who depends on the investments themselves to supplement income. That said, some investors who know they have all their expenses covered already don't need to take a lot of risk because they don't need the investments to "work" as hard for them.

See Also: When It Comes to Investing, Diversification Is Not All the Same

4. Are your investments well spread out?

Is the portfolio highly concentrated in only a few stocks? What is the predominant makeup of the investments? Is it all in large-cap growth? International? U.S.? The more diversified an equity portfolio is, the better the chance it can potentially minimize losses in a declining market. I use the parachute theory. The bigger the chute, the slower the fall, so spreading out the investments wider in a volatile market may help minimize the impact of a market drop.

5. Are there other considerations to factor in?

Sometimes there are other factors that affect risk tolerance, such as the likelihood of an emergency for needing money that they never intended to touch. You should also consider your future earning potential or what would change if you received an inheritance. Is there a chance you will care for an aging parent or support a child moving back into your home?

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Getting the answers to these questions goes much further to assessing your risk tolerance than a standardized questionnaire. I will usually go a step further and try to reframe the questions in different ways to see if a client will answer the same question differently. That’s because some clients may at times answer a question the way they think I want them to respond. Meaning they know the “right” answer, even if it doesn't accurately reflect how they feel about the risk. So, don’t be surprised if your adviser asks you the same question a few times, and always answer from your heart.

It all comes down to helping your adviser truly get to know you and what's important to you. It's not always easy to figure out at first when investing, but in time, it will become more apparent when you go through different market cycles together.

The way I usually handle new clients is to suggest slightly more conservative investment than the client’s risk tolerance at first until they have had a positive experience or been through a market change. Once I know how they react, we can begin to alter the risk up or down as necessary.

See Also: Retirees: Don’t Make the Same Mistakes Before a Market Correction

Securities offered through Kestra Investment Services LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney or tax adviser with regard to your individual situation.

T. Eric Reich, President of Reich Asset Management, LLC, is a Certified Financial Planner™ professional, holds his Certified Investment Management Analyst certification, and holds Chartered Life Underwriter® and Chartered Financial Consultant® designations.

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