General Advice - EMOTIONAL & FINANCIAL RISK TOLERANCE


My goal is to help you using general advice  to implement an investment strategy that will maximise your chances of achieving your financial goals while retaining the sleep factor.

You need to consider your tolerances to investment risks (both emotionally and financially).

Financial Risk Tolerance
The risk of the underlying investments failing to meet your goals is your financial risk tolerance. Overly conservative and aggressive strategies both pose dangers.

It is commonly held that there is an inverse relationship between the expected return from an asset and the "risk". In other words, you should expect a lower return for accepting a lower risk. But this is not always the case.

Which is safer, cash or shares? Theoretically it's cash. But it really depends on your time horizon.

"Low risk" assets like cash and term deposits are tax ineffective and offer no capital gain potential. Holding these sorts of assets on their own increase longevity risk, the risk you outlive your investments by living too long. If you remain invested in cash, and earn around 5% per annum (taxable) for a net return of say 4% p.a. then it will take 18 years for your investment to double instead of every seven years typically for shares. 

The history of Australian shares over 100 years shows that, over every 20 year period, no matter when the starting date, including periods of global wars and depressions, the ASX All Shares Accumulation index has outperformed cash. Even if you invested on the day before the 1987 crash!

While counter-intuitive, an investment in the sharemarket over any 20 year period can be entered into with much greater confidence than if your horizon is under five years. On a one day to three year view, it's quite difficult to even predict the direction of the sharemarket.

High growth investments like shares are subject to short-term capital risk. If a downturn on the scale of 2008 coincides with a dependence on drawing capital from the portfolio to meet living expenses you risk running down your capital rapidly. This is capital drawdown risk and is a measure of your financial risk intolerance.
 



Emotional Risk Tolerance

There is no benefit in adopting a growth  strategy if you bail out at the bottom of each bear market.

How comfortable are you with share prices going up and down like a yo-yo for no particular reason?  Most people can tolerate some volatility. But what happens if markets fall day after day, month after month, for over a year? Even hardened professionals begin to question their faith.

If you are used to taking calculated risks, and are sanguine about short term market movements then you have high emotional risk tolerance.

If you are sensitive to short term loss in value, and anxiously watch the market values daily changing for your investments then you probably have low emotional risk tolerance.

Your stage of life
Highly paid working investors saving for retirement probably benefit from a fall in market prices providing they continue to augment their portfolio from savings.  Their financial tolerance is high.

Retired investors face a different issue. Retired wholesale clients usually have sufficient assets to fund a comfortable retirement lifestyle. After a successful lifetime of taking calculated risks, their emotional risk tolerance is ahead of their financial risk tolerance. The dramatic fall in share prices in 2008 should be a wake-up call for many to reign in enthusiasm (once it's gone up again).

Benefits of professional management
Transparent reporting of a widely diversified portfolio managed and administered by caring professionals, goes a long way towards making the emotional experience of investing in the stockmarket more rewarding and enjoyable.