Risk Management

Date postedMay 10, 2024

Decisions and constraints investors face can be compared to driving to a destination. Before the trip, the driver will estimate the time it takes to arrive and adjust how fast or slow they need to go to arrive on time. Along the ride, several factors affect the journey, such as the speed limit, vehicle reliability, traffic conditions, and how much gas is in the tank. Additionally, the driver's personal preferences will kick in and shape the ride; the driver may experience a thrill by driving quickly, or one might find it enjoyable to take hard corners despite the risk of suffering the consequences of the law. Others may feel more comfortable driving at the speed limit and using caution. Several factors influence an investor's journey, much like the driver's. We can categorize the factors into two: 1) The investor's ability to take risks and 2) The investor's risk tolerance. The investor's ability to take risks can be likened to the driver's circumstances, and the investor's risk tolerance can be comparable to the driver's preference. Both an investor's ability to take risks and the investor's risk tolerance are critical when investing.

Risk ability or capacity refers to an investor's ability to handle a loss without significantly changing their quality of life; the risk an investor can responsibly take without jeopardizing their financial picture. Similar to the circumstances of our driver, such as the speed limit, gas in the tank, and vehicle reliability all play a role in determining the driver's journey; an investor's time horizon (the amount of time they will be invested), age, income, future income potential, and net worth determine their ability to take on risk. A longer time invested, younger age, higher earnings, and greater net worth all indicate a high ability to take on risk. All these factors suggest that investors would be safe from jeopardizing their financial picture or future if they experience a severe negative return in a given year.

Risk tolerance or willingness to take risk refers to an investor's risk preference and view of investing psychologically. It represents the maximum uncertainty an investor will accept when making a financial decision. Going back to our driver, this would represent the driver's preferences and experience in driving. Some may love going from 0 to 60 as quickly as possible, while others prefer a calm, relaxed journey. Those who prefer a smooth, calm ride would like to avoid significant fluctuations in their portfolio on a short-term basis. Does the fluctuation or thought of a potential decrease in the portfolio affect the investor's day-to-day life? Being comfortable with a 15% decrease may sound fine on paper; however, when this happens in the real world, and the investment portfolio drops from $1 million to $850,000, investors tend to have a more adverse reaction. Economic challenges and widespread fear typically drive the decline of an investment portfolio. It can be challenging to look past the short-term difficulties and believe your $850,000 will return to $1 million when the economy appears to have nowhere to go but down. Investors with ample experience and knowledge in investing who can tolerate sudden short-term drops in the markets are considered to have a high-risk tolerance. They can tolerate a portfolio that is high risk without having it affect them psychologically.

If an investor's ability, tolerance, and willingness to take risks conflict, generally, it is best practice to take the more conservative approach. The ability to take on risk can evolve with the assistance of an advisor.

Below are two examples of individuals with different risk tolerances and abilities.

Case #1:

Bob is in his mid-40s and plans to retire within the next 15 years. Bob's investment portfolio is worth $6 million, and he currently lives on $7,000 monthly. Bob owns his home (worth $1.5 million) and enjoys fishing and travelling with his wife. He holds a vital role in his company, making close to $400,000 a year, and can save over half his income. Bob understands the financial markets well and has lived through numerous recessions – through the years, he has remained consistent in his investment philosophy and knows that markets tend to go up over the long run. Bob would like to achieve a high long-term return, knowing this means there may be more volatility (up & down) in the short term.

In this case, Bob has an increased ability to take risks and has a high-risk tolerance. Bob's ability to take risks is evident through his consistent, stable, and high income. He has a sizable net worth and plans to be invested in the markets for the next 40 years (he will be investing throughout retirement). Bob has a relatively long time to retire and has a strong professional skill set. If the portfolio were to drop by 20% in the short term, Bob's quality of life would remain the same. Bob's risk tolerance is also high. His extensive knowledge in the investing realm demonstrated calmness in the face of portfolio value decreases (having experienced several recessions), and his objectives of achieving a high return for his portfolio make it evident.

Case #2:

Molly is in her late 60s and wants to retire within the next 1-3 years. Molly is single and lives a modest life; however, her investment portfolio is small. She will depend on the portfolio to live on when she retires, along with government pensions. Her planned lifestyle in retirement has her withdrawing from the portfolio at a rapid pace. Molly still has a mortgage on her home (10 years left on it) and has been out of work occasionally throughout her career. Molly mentioned that she can tolerate a high level of risk and realizes that her portfolio needs to generate a +12% return each year to fund her retirement (very unlikely and unrealistic). She has some experience investing and is aware more risk means more ups and downs in the portfolio. After experiencing several bear markets, Molly feels like she can bear the psychological downturns in the market. Molly views her risk tolerance as high (psychologically, she can take on risk); however, her circumstances do not permit her to take on such risks.

In this case, Molly's ability to take risks is low, while her risk tolerance is high. Because the two conflict, we would opt for the more conservative approach, which would constrain the amount of risk taken. Molly will start withdrawing funds from the portfolio at an unhealthy rate in the next year or two. Even though Molly can handle more risk (psychologically), she should not put herself in a position to take on more risk as she can't afford to experience a 30% decrease in her portfolio over the short term. Such an outcome could be catastrophic for her retirement nest egg.

Molly's situation is unfortunate; however, she can use pit stops and refuelling stations to change her retirement picture. While Molly may not be able to achieve her retirement solely based on her investment portfolio returns alone, there are other solutions. A few options Molly has to change her situation are as follows:

  • Contribute more to the portfolio each month (this will make a significant impact as her portfolio is small)
  • Work an additional few years
  • Work part-time in retirement so that she does not have to rely on the portfolio so heavily
  • Decrease the amount she takes out of her portfolio in retirement (reduce her withdrawal rate)

Risk tolerance and ability can easily change over time, usually caused by life-changing events like the birth of a new child, entering retirement, loss of employment, or a large inheritance. Because these life events and changes are inevitable, risk tolerance and ability must be re-addressed frequently, and the corresponding adjustments must be made. Just as a driver adjusts their speed and route based on various factors, investors must assess their ability and tolerance for risk to reach their financial goals successfully. 

A time trial race commonly known as the Cannonball Run challenge measures how fast a driver can get from New York to LA. The current record holder has averaged a speed of 182km/hour, far exceeding speed limits. The driver is supported by a passenger who helps prepare and navigate the journey's challenges. Preparation includes:

  • Planning the route.
  • Monitoring traffic conditions.
  • Using police radar detectors.
  • Taking on additional gas tanks.
  • Planning scouting trips up ahead of the route.
  • Even making the vehicle stand out less.

Similar to the preparation and ongoing maintenance that the driver and passenger do when embarking on a Cannonball Run, a team can considerably help investors achieve better results on their financial journey. As Wealth Counsellors, we help our clients maintain the appropriate speeds, avoid major problems or traffic jams, ensure comfort, make sure the correct route is taken, and help assess the road ahead. All play critical ongoing roles during one's financial journey.

By recognizing the interplay between risk capacity and risk tolerance, investors can make informed decisions about their portfolios that align with their long-term objectives and personal comfort levels. Whether Bob, with his ability to take risks and corresponding high tolerance, or Molly, facing a conflict between her psychological readiness and financial capacity, each individual's unique circumstances shape their investment journey.

At Kinsted, we recognize the importance of tailoring investment strategies to find a suitable portfolio that matches an individual's risk ability and risk tolerance. Our Wealth Counsellors dedicate themselves to guiding clients through this process, ensuring their portfolios can withstand market fluctuations while pursuing their desired financial outcomes.

In the ever-changing investing landscape, prioritizing risk management is essential for achieving sustainable growth and safeguarding financial well-being. With the right expertise and support, investors can confidently navigate their financial journeys. Let us help you chart a course toward a brighter economic future, contact one of our Wealth Counsellors today.