Assessing Investor Risk Tolerance
Why foundations and private clients are not all that different when it comes to risk
The fall has brought with it turbulent markets and the excitement has some clients responding emotionally to the impact on their portfolios. The average person feels the pain of loss about two times more than the joy of gain. Therefore, it is not surprising to see investors get nervous when the market is going down. We have long encouraged clients to stick to their investment plan and strategic asset allocation, ignore the short-term market gyrations, and focus on the long term.
But how do you decide what the right strategic asset mix is? It comes down to your “risk tolerance”. In other words, this is your ability to endure the inevitable variability of investment returns and, in particular, the times when your portfolio shrinks in value. There are two parts to determining your risk tolerance. There is your financial capacity to bear risk and your personal comfort level with risk. Your financial capacity to bear risk is the traditional approach that looks at a number of key variables that include:
- your time horizon,
- your income,
- the size of cash withdrawals relative to the size or your portfolio and
- any liquidity requirements you may have.
The sleep at night factor
Your personal comfort level with risk is what we call the “sleep at night” factor. You need to ask yourself if you are comfortable with the asset allocation in your portfolio, such that you are not losing sleep when the market moves lower.
An investor’s decision about how to allocate a portfolio among cash, bonds and stocks ultimately influences the performance of that portfolio. The right asset mix for you today has major consequences for your future wealth. Unfortunately, the short-term performance of a portfolio is also sensitive to the asset mix that you choose. In an investment environment with lower-than-expected returns, it becomes even more challenging to determine the optimal asset mix. You don’t want to be taking on more risk than you can bear in search of higher returns, especially if you don’t have the financial capacity to bear risk. As it turns out, finding the right mix is not just a challenge for individuals, but also for foundations.
At Nexus, we have found that private clients and foundations have many things in common, including the same variables that go into determining capacity to bear risk. Private clients need cash flow from their portfolios to live on and foundations need to distribute a percentage of their capital each year. Private clients work all their lives and save money for retirement which can last 30 years or longer. However, once retired they do not have the ability to replace capital. Many foundations do not have an on-going fundraising program, so they are not replacing their capital. Nonetheless, they want to ensure their assets and spending power last in perpetuity.
We have written two articles about them. The first is about the perpetuity challenge many foundations face and how the investment strategy chosen can have an effect on portfolio longevity. The second article takes a view of the role of a foundation trustee.
Are you unsure about your foundation’s asset allocation? At Nexus we help foundations with financial counselling as well as investment services. Contact us today for a complimentary consultation.