Risk Tolerance

While academics and investment professionals define risk as “fluctuation” or “volatility,” most people see risk as the possibility of incurring a loss.  An investor who experiences a dramatic increase in the value of a stock, for example, may not see it as risky or volatile.  Instead, the rise is interpreted as a confirmation of a correct decision to buy it.

What is not appreciated, unfortunately, is that the rapid rise in a stock’s price is not the result of what the investor knew at the time of purchase.  Instead, it is the result of new and positive information, unknown at the time of entering the market, that caused a rerating of the company and, hence, an increase in the price of the stock.  In short, significant price movement or volatility is the result of surprise.  The source of that surprise may be economic-, industry?, or company-specific.

Now surprises can be good or bad, thus moving markets accordingly.  Individual investors are typically slow to change their views when news is bad.  Rather, they cling to their original rationales–”it’s a good company,” or “stocks go up in the long term”–and thus may suffer significant losses as a result.  Moreover, individual risk tolerance is not stable.  It is like a rubber band expanding and contracting based upon the individual’s recent experience and events.

We often see investors taking on more risk than they need to because they haven’t discovered that they can reach their goals with less risky investments.  Others take on too much risk simply because that’s what their friends or coworkers are doing, or they may invest in a risky mutual fund because it’s been hot for a few years.

It’s tough for most folks to be objective about their risk tolerance.  MCS Financial Advisors recommends having an experienced and informed third party evaluate your risk tolerance because the majority of investors have only limited experience with this.  For example, several years of above-average market performance such as we’ve recently experienced may skew and investor’s own judgement of market risk.  Moreover, proper evaluation of risk extends beyond the portfolio to include consideration of the risks in an investor’s personal balance sheet, employment, and insurance protection.

When choosing a third-party advisor, investors will find that most are paid commissions or other forms of compensation.  Such advisors bear an inherent conflict of interest and may not provide impartial advice.