How to Assess your Risk Tolerance
Bob is a 38-year old father of two young children. His wife is a stay-at-home mom who makes a living doing small sewing jobs. Bob works in the trades. His monthly income is sporadic at best, since it depends heavily on insurance claims and the economy. Bob and his wife have a monthly mortgage payment, a car payment and two student loans. Their budget is tight; they’ve had to cut back on entertainment costs and forfeit their yearly vacation.
A friend suggests that Bob invest in stocks – he’s sure there’s a ton of money to be made. Bob thinks this might be the solution he’s been waiting for, so he takes his friend’s advice and makes the investment without consulting his wife.
Clearly, Bob hasn’t thought this through and his wife tells him so when he gets home from work. Where did Bob go wrong? Read on to find out.
Assessing your Risk Tolerance
Most investments have a certain amount of risk. The goal is to strike that balance between risk and return. Before making any type of investment you should first determine your own risk comfort level. To do this, consider the following questions:
Q 1. How would you describe your understanding about the market and the different financial instruments available to you:
- Definitely limited
- I’m about average
- I’ve done some investing, took some economic courses in university and dabbled in mutual funds so I’m above average
- Call me Warren Buffet
Q 2. What would best describe your past investments:
- Little to none
- Mix of chequing and savings accounts
- Mix of savings, GICs and some mutual funds
- Everything from A-Z!
Q 3. I am looking to save/invest for:
- Less than 1 year
- 1-3 years
- 3-5 years
- More than 5 years
Q 4. How would you describe your strategy/objectives for your investment?
- I’m really just looking for somewhere to park my money, without any risk. It’s important to have access to it whenever I need it. After all, my car is getting pretty old.
- I won’t need this money for the next year, maybe even the next couple of years so I don’t mind locking it up. I like the idea of knowing that it will earn some interest but I definitely don’t want to lose anything, I’m pretty conservative and want to know my money is safe!
- With the low interest rates right now, I’d be interested in seeing what other options are out there. Realistically, I don’t need this money for a couple of years (at least) and I would be comfortable with some risk. Right now my option is earning less than 2% annually! Once the government taxes me on it I’m left with peanuts. Since less than 2% is all I’m giving up I would be ok with seeing my investment fluctuate in value and I definitely wouldn’t cash-in if I see prices go south. I have faith that the value will come back up over time.
- Go big or go home! I have zero interest in the insulting GIC/savings account returns. I’m looking to build my retirement savings and unfortunately have many years before I get there. I know that markets cycle through growth and recessionary periods but one thing’s for sure – the overall trend is upwards and I definitely have the time to ride out the waves of the market.
Q 5. Risk vs. Return... where do you fall?
- Risk!? That sounds scary, no thanks!!
- Hmmm... risk or return. If I have to choose one, I’d say return.
- I’m ok with some risk, as long as it’s researched and calculated. I understand that you have to take risks sometimes for the opportunity for a bigger return and I’m not one to put all of my eggs in one basket. I’m diversified and I do have a nest egg to fall back on if need be.
- I have a good understanding of markets and surely understand the balance between risk and return. I tend to be a little riskier because I have a long-term time horizon.
Q 6. What is your overall net worth?
- Hmmm this takes me back to accounting101 ... that is assets minus liabilities, right? Well, I invested in my education and have some student debt to pay off. Eeek! It’s technically in the negative.
- I’m proud to say that I’ve gotten my debt under control and I’ve actually managed to save a bit of money. I’m really looking to put it away so I don’t spend it.
- I’ve been working for a few years now so I’d guess somewhere between 12,000-$15,000?
- ... $15,000 +
Q 7. What does your overall portfolio look like?
- Portfolio is a pretty fancy word. I don’t really have much. There is my chequing account, I’m looking for a savings account and I have a low limit credit card.
- I have my main chequing and savings accounts, I own a car and have a small loan that will be paid off soon, I have a credit card and I have a Canada Savings Bond that my grandma bought me a couple years ago maturing soon.
- I have a chequing account, a high interest savings account, a TFSA, a GIC or two and I’m starting up an RRSP.
- I have a chequing account, a savings account, a TFSA, RRSPs, I’ve started an RESP for my kids, I have a mortgage, what else? I’m pretty established, I feel like if it’s offered, I have it!
Q 8. Let’s pretend that you just won $10,000 on a scratch and win ticket, so you head to the bank with your cheque and are offered the following, what would you chose?
- 0.85% annually, guaranteed. And you can use the money whenever you want! (Likely you just paid off your credit cards and some other minor bills and only have $2,000 remaining)
- 2% but you can’t access the money for 2 years (You decide that you’re going to take a little of it to spend on a new wardrobe, but it would be a good idea to have the money out of sight and out of mind so you aren’t tempted to blow it all)
- The financial advisor at your branch talks to you about mutual funds. Your money could potentially grow to $11,500 or it could be worth only $9,500; it really depends on the market. But the other option at 2% is only $200 after 2 years!!! Hmmm, You decide to take your chances with the mutual fund and hope the market is gentle.
- Yes, $10,000 really helps but in the grand scheme of things isn’t going to make or break you. The advisor at the branch mentions a riskier mutual fund could pay off and be worth $13,500 or maybe only $6,500. You were feeling lucky and it paid off with the ticket, so you try to go two for two and be a little riskier!
If you answered mostly:
1’s: NO RISK! You’re just getting started and should consider parking your money in a savings account. Who knows what the next month will bring! Compare savings accounts for your options!
2’s: CONSERVATIVE! You’re all set up with your chequing and savings account and maybe you’ve even established a balance in your savings account that you want to earn a little more interest on, but you're not interested in risking any of it. Best option would be a GIC, compare GIC rates to find the best one for you.
3’s: MODERATE RISK! You’re sitting pretty and you seem to know what you’re doing! If you haven’t already done so, you might want to check out some balanced income mutual funds. Visit your bank branch or speak with a financial advisor for options on mutual fund portfolios.
4’s RISKY! You’re very knowledgeable about the markets and you can afford to be because you’re established, diversified and you have a long-term time horizon. If you haven’t already done so, you might be well suited for an aggressive growth mutual fund. Contact a financial advisor for the best advice.
Types of Risks
With most investments there’s some element of risk. In an economic downturn your investment might suffer an economic risk, since financial markets are usually affected all across the board.
Sometimes specific industries suffer a downturn. If this happens, related industries can suffer as well. With an inflation risk, the long-term value of an asset, such as a government bond, does not keep up with inflation.
Credit risks are a possibility as well. If the issuer of the investment does not live up to their financial obligation, you could lose not only your invested capital, but your expected returns as well.
With some types of investments, there are market risks to consider. If your investment declines in value and you try to resell it, you could end up losing even more money.
If you’re new to investing, try investing in RRSPs or GICs since their security is ensured. Learn as much as you can about your potential investment before making a final decision.
So where did Bob go wrong?
While Bob is still fairly young, he has a family of dependents to think about. Although his wife does a great job of taking care of the family, she doesn’t bring in a lot of money. Bob’s family is already on a tight budget and his own income is both low and unreliable.
Worst of all, Bob has made a quick, irrational decision to invest money he couldn’t afford to spend in the first place. In his excitement to make a lot of money - and quick – Bob didn’t consider his family’s future. Bob’s plan was a risky gamble – not a sound investment.