Risk Tolerance – Part 1 (Concept)

In this video we cover a very important concept in Finance… Risk Tolerance!

VIDEO SUMMARY

Risk tolerance is a very important concept in Finance. It is a concept that I think people could spend a little bit more time really understanding. It is that important. That is why I am making this video. Risk tolerance is basically a pretty simple concept. It is the idea that each financial decision has two components: it has market forces (what is going on in the market) and then it has the individual investors’ situation. The idea is that if you evaluate both of these components, aligning these components will give you the best financial decision.

I am going to use some charts to give you an abstract understanding what this means. The first chart is going to show two axis. On one axis is risk and the other axis is return. This is the concept that we have been discussing. It shows that the higher the risk, the higher the return. This is all about understanding market forces. If you understand this curve, you are understanding what is going on in the market and what investment opportunities are available. I am going to put up a second curve. This curve is all about understanding individual investors’ situations. This curve says the higher the risk the lower the peace of mind. It is trying to say, for an individual investor, the more risk they take on, the less peace of mind that creates for that investor. The idea is that when you combine these two charts, based on what is going on in the market and based on what is going on for the individual investor, where those two lines intersect is going to be that sweet spot. That will be the point where an investment has the right amount of risk for the individual investor. That is what we are trying to do here. We are trying to align the riskiness of investment decisions with the appropriate level of risk for that investor. Because each investor has a different financial situation, that point is going to be different for every situation. So when we talk about risk tolerance, it is all about understanding this second part: the individual investors’ situation.

I’ll give you an example. Let us look at the first curve where the higher the risk, the higher the return. You can be a brilliant investor, you can really understanding the financial markets, really understanding what market forces are doing, and make brilliant financial moves at the very high end of this risk-return spectrum, but if your individual situation does not warrant that level of risk, then it does not matter how brilliant those financial decisions are. It is not appropriate for your financial situation, and perhaps better financial decisions could be made at lower levels of risk.

The problem when you talk about risk tolerance is that it is very difficult to quantify. It is very hard to come up with a quantitative number for your level of risk tolerance. So what normally happens is you go to a financial professional. Usually they have some kind of survey and they try to get a general overview of your financial situation. So you will fill out this survey and it will ask you things like “What is your level of savings? How much are you saving every month? What types of investments do you have?” They get this picture of your overall individual situation and then make a determination on what is the appropriate level of risk for you. The goal is to find what would make you feel the most comfortable. That is how it is normally done, through these surveys and that makes it really difficult because it is not always a quantifiable number. It is about understanding the full situation.

However, I think there is quantifiable information here that is helpful to understand. When I look at risk tolerance, the main driver always comes back to one thing. It comes back to what is your reliable monthly income. So you have all these financial factors, but the main impact on how you are making your investment decisions is going to be “What is your income every month and how reliable is it?” Let me give you a couple of examples of this. I am going to put up some different examples. In this chart, on one side we have the more risk-averse option and on the other side we have the less risk-averse option. The most common example of risk tolerance is someone nearing retirement. With someone nearing retirement, their main driver is again, reliable monthly income. But if you are nearing retirement, that monthly income is going to end very soon and so you are going to be more risk averse than, for instance, somebody with many years of income earning potential. This is a comparison between two different individual investors with a different level of risk tolerance based on the reliability of their monthly income. Let us take another example. Let us look at job security. Someone who has low job security is going to be more risk-averse than someone who has a very stable job, because again it comes back to the reliable monthly income. If you are worried about losing your job, you need to be concerned about having enough savings to make up for the loss of earning potential. So you have those two different options: low job security is more risk averse while a stable job is less risk-averse. Let us look at another example. Smaller paychecks versus larger paychecks. If you have more money coming in, you are going to be less risk-averse and able to take on more risky investments. Someone with a smaller paycheck is going to have less money to invest so they are going to be more risk-averse or willing to take less risky investments. Again this comes back to the idea of finding what is the most appropriate financial decisions for your individual situation. I have one more example. Consider someone with one income stream versus someone with diversified income streams. Let us say the diversified person has a paychecks from their job, they have rental income, and they have investment income. They have all these different streams of income coming in every month. Another person with only one income stream is not going to be as reliable as someone with a diversified portfolio. So again, that makes their outlook on financial decision-making different based on their individual situation.

So I hope walking through these examples is helpful. The key is you want to understand risk tolerance because it helps you make better financial decisions. It is important to thoroughly understand your situation and decide how far up that risk return scale is appropriate for you. Because what we want to do here is we want to help you achieve your goals in the most financially responsible way possible. The main driver of risk tolerance is going to be the reliability of your monthly income and how much money you are willing to lose. So to recap, we talked about risk tolerance in this video. I gave you a definition of risk tolerance. We talked through assessing your risk tolerance. Then we gave some examples of different risk levels. This is a really important concept to understand, and I am going to make another video on it. In the next video, we are going to take specific quantifiable values and talk about what that means for risk tolerance.

Thank you for watching. Leave a comment down below letting me know what you think! The best way to supercharge your business is through accounting and corporate finance. I release a new video every week, so come back and check out next week’s video.

If you find these videos helpful, please subscribe to my YouTube channel.

Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.