Episode Transcript
Brenton: [00:00:00] An investor's risk tolerance can help determine how conservative or aggressive the investments in their portfolio should be.
But is your risk tolerance the same no matter what investment you choose? In this episode, we find out.
Brenton: Hello, this is Brenton Harrison of New Money, New Problems, and your host for the New Money, New Problems podcast. In our most recent episode, we talked about the inner workings of the s and p [00:01:00] 500, and we talked about how it is comprised of 500 large cap companies that are seen as the gold standard when it comes to index funds and portions of the market that you should track.
And at the end of that episode, we talked about how even though over a long period of time, the s and p 500 has a strong track record of returns, it is what's called market cap weighted.
And what that means is that the more cash rich companies on that exchange have a higher weighting and an influence on the comings and goings of the index. And as a result, when you see a lot of volatility in sectors like tech and sectors like energy, in some cases, you can have the s and p 500 due for a wild ride. Even though over the long run you might be pleased with what those returns may be. And in describing that volatility and explaining why that might be problematic for a person who might need their funds in a shorter period of time, or who may just not have the stomach to watch it rise and fall, I introduced a term called risk tolerance, and that's what we're [00:02:00] digging into in this episode. Risk tolerance is truly a term that describes your appetite for risk. It expresses how much volatility you can watch in your investment or your portfolio before you feel the need to make a change. As an example, if I have an account where the upside of that account on average may be 18 to 24%, I may be pleased until I discover that the downside of that account is negative 18 to negative 24%.
And if I were going to look over a three month period and see my investments down 24% in 90 days and feel that would necessitate a change, I am signaling that that investment is outside of my risk tolerance.
The level of volatility is not something that makes me comfortable on a day-to-day, month-to-month basis.
Now there are many different categories of risk tolerance. There is conservative, there is moderately conservative, there is moderate, there is moderately aggressive, there is aggressive. In some instances, institutions will use very aggressive or very conservative as [00:03:00] these different segments in which you can fall and categorize yourself as an investor.
But to me, one of the big shortcomings of the risk tolerance conversation is making sure that the end user understands that your risk tolerance can change depending on the investment in which you're participating.
Let me give you an example that will make it more clear. When I was 23 years old, I started investing in my 401k. And if I'm going just off of the basic age most people will be before they start accessing retirement funds, that meant that 36 years from the year I started that account would be the first year that I would plan to access those funds. And as such, I can deal with a lot of volatility. I'm not looking at it every day. Even if I was, and I saw a big drop, I don't need the money for three plus decades. And as a result, I can afford to invest more aggressively in that particular account.
But when I was 25, my wife and I bought our first home as a couple. And the money that we set aside for those previous two [00:04:00] years went into an account. And we knew that there was a line in the sand, where we were going to need those funds in order to make a purchase. And as a result, the level of aggression that I had in my 401k would've been completely inappropriate to use in an account where we were putting the funds that were used for the down payment. I might be a very aggressive investor at heart, but in terms of my risk tolerance for my down payment funds, they may need to be invested very conservatively to make sure those funds were there when I need it.
So when it comes to deciding your risk tolerance, you're not deciding whether you as an individual are conservative or aggressive, even though you might have your feeling as to where you land at heart. You're really deciding how volatile can I be with this particular investment at this particular time. And that can dictate your risk tolerance for that one account.
So what I thought we would do is go through five factors that can influence the risk tolerance you have for each particular account, starting with your time horizon. And time horizon [00:05:00] is how long you plan to go before you access the funds that are held in your investment.
Going back to my 401k example when I started the 401K at 23, my time horizon was three plus decades. Whereas the account that we used for our down payment had a time horizon of three years or less. And as such, volatility in that account would've been much more damaging than if it were in the 401k. So we have to adjust our investments accordingly.
But you also wanna make sure that if you're in a 401k and you consider yourself a conservative or a moderate investor, that you don't use that label you've placed on yourself to keep you from the potential large returns that can come from being a little more aggressive if you have those same 20 or 30 plus years.
Just because it makes you a little nervous to have money that's more volatile, it does not mean that you should put your 401K funds in something that's conservative because of something that makes you sweat. And before I go on to the next factor, I want to drive this point home by discussing what [00:06:00] happened in 2022.
Last year most investments were down and they were down thoroughly. And it's definitely not a fun thing to see. It's not a fun thing to talk to clients about when you're talking about investments you're managing that have lost money, and it's not fun to watch my accounts go down either. But when I talk to people who are so frightened and asking if they should pull their money out of the stock market, I wanted to make sure they understood what they were feeling internally.
And that is this: if you're under the age of 50 years old, you might have been working during the 2008 financial crisis, but it's unlikely that you had any amount of significant funds in the market in 2008.
So if you were in your first or second job, you might have been watching people get laid off and watching the stock market go crazy. But at that time, maybe you had 5, 10, 25. $40,000 in your 401k. And while it took a hit, it was not as devastating as you having 150, 200, $300,000 in a 401k, as some people did last year, and watching it go down 50, [00:07:00] $60,000 over the course of six months.
That hurts to watch. And it hurts even more so because between 2008 and 2022, we had an extremely strong market, and it's unlikely you experienced a loss of anything near what you saw last year during that stretch of time.
So while watching your money go down like that has a visceral reaction, you have to understand that you still have a long time horizon on those funds. And with accounts like a 401k, as long as you are putting money into that account on a consistent basis, you are hopefully buying low during these periods of volatility. And in the long run, as odd as it sounds, you may be thankful for periods where the prices of these stocks and mutual funds and index funds were depressed during a period of time that allowed you to buy low and eventually sell high.
[00:08:00] [00:09:00]
Brenton: The next factor that can influence the risk tolerance you have for a particular account or investment is your net worth. There's a term called Accredited Investor that the Securities and Exchange Commission uses to determine who theoretically should have a better idea or a better ability to determine what's going on in a complex investment tool. And when you're an accredited investor, you are able to participate in certain security offerings that you are not, if you're unaccredited.
The idea being as an accredited investor, you can read through the reports and the details and all of the things that influence its performance and have a better idea than a layperson of whether or not it's a good fit for the rest of your finances. Now, I would disagree that meeting one of these three tests suddenly means you have a heightened knowledge when it comes to evaluating investment opportunities. But I do think there is validity to the fact that not all investments are for everybody.
And you could be in a situation where you are investing in [00:10:00] something that is way too volatile or too complex based on the rest of your finances. As an example, if you're investing in something that is extremely volatile and you have two months expenses to your name in cash, you're not in a position to lose that money.
And as such, you shouldn't be investing it as aggressively.
The third factor in determining your account's risk tolerance is your investment objective. As we've talked about investments over these recent episodes, we've covered that different investors have different objectives when they're entering into an offering.
You have some people who invest in stocks that they are hoping fly to the moon in terms of their valuation, and they plan to sell some or all of their shares for a profit. Whereas there are other investors who are looking for dependable and passive income. And as a result of that, they invest in what's called dividend stocks.
And dividend stocks are companies that have a history of taking their excess profit and distributing them to investors. Now, dividend stocks may by their nature be more moderate or more conservative.[00:11:00] And even if you're an aggressive investor at heart, your objective for this particular piece of your portfolio might dictate you being more conservative than you may typically be.
Conversely, if you're on the other side of the fence where maybe you're not even looking for growth oriented investments, but the taxation of your investments is a big deal, your objective may be to invest in tools that don't kick off as many gains, and as a result, dividend stocks may be your worst enemy.
But you also may have problems with things like real estate investment trusts, things that may speak to you in normal times, but also kick off significant taxable gains from year to year.
And that brings me to the fourth factor, which is your investment experience. And investment experience to me is the culmination of things like your net worth, the accredited investor test, your investment objective, and the ability to teach something to not only yourself but someone else. If you are going through something that is complex and you have no experience in it and you can't understand it well enough to teach it to someone [00:12:00] else, there are certain things that might be present in that investment offering to which you're unaware that can be really damaging. I just referenced a reit, which is a real estate investment trust. And now I want you to assume that we have two listeners who are hearing this episode.
The first listener, has been with us since the trailer to now. They've heard every single episode. They've taken notes, they've applied it to their situation, and because of that, they heard me talk about REITs a couple episodes ago. And at that time I shared that these tools provide passive income, but that they are required to distribute at least 90% of their income to their shareholders each year.
Now, that is a great tool if you're looking for passive income, but it can lead to gains. Now, let's assume that the other listener did not hear that episode, and this is the first time they're tuning into the New Money, New Problems podcast. They've never invested in a reit, but because someone told them that it provides passive income they put money into that without understanding it, and at the end of the year they get a big [00:13:00] tax bill that they weren't expecting and don't have the money to pay. The first listener's experience with this investment and experience with the other lessons that we've shared gives them a better shot of evaluating a REIT to decide whether or not it's for them. Whereas that second investor's lack of experience might put them at a disadvantage when they're trying to evaluate that same real estate investment trust. The knowledge and history you bring to the table matters when you're making a risk tolerance decision.
And then lastly, what are your liquidity needs for this investment? And if you've been following along, the first factor was time horizon. And it may seem like time horizon and liquidity needs are the same thing, but there are some small differences. The time horizon of your investment account could deal with how long before you need to consistently access those funds.
Liquidity needs may be things like how quickly you need to access the money in a pinch, and whether or not there's a penalty for doing so. As an example, when my wife and I started saving for our down payments at 23, we knew that two years later, at [00:14:00] 25, we would needed to put down on the house.
That means any investments we chose for those funds needed to be very conservative. Now, let's say that we went and found one of the most conservative investments we could, which could be a certificate of deposit. And we took that money for the down payment and we put it in a 36 month CD at our local bank.
Well, even though that CD might be conservative enough to meet our time horizon, we could not access it in full without penalty in 24 months when we need to make the down payment so it doesn't meet our liquidity needs.
Another example might be a person who's 30 or 40 years old and wants to start a business in the next five years. So they start putting money into their 401k and maybe the level of aggression meets their time horizon and even is aggressive enough to meet their investment objective. But because you can't access these funds without penalty, in most cases until 59 and a half, it does not meet their liquidity needs.
So that's it. Five different factors that can help influence your risk tolerance for each particular account, because as a reminder, your [00:15:00] tolerance in each account should be different. And what we'll do is in the resources for this episode, we'll put a link to an actual risk tolerance questionnaire you can take for yourself.
And remember that the questions that you give should differ based on the account that you're evaluating. If you like what you're hearing and you haven't already joined our email list at newmoneynewproblems.com/podcast. And if you have a question you want us to cover or an episode you want to hear in the future, send us a message and it might be the next thing you hear on the New Money, New Problems podcast.
See you soon.
