Your personal tolerance for investment risk should drive your asset allocation decision – A Tip from The Skilled Investor

Your tolerance for investment risk is a relative thing. Few people like investment risk, but some can handle it better than others do. The more investment risk you can and are willing to tolerate, the higher your potential expected investment returns and investment growth might be. At the same time, the investment road you will take might be rougher.

Also, the scientific finance literature has shown that securities markets tend to pay a return on investment only for shouldering investment risks at the market level — not at the level of individual securities holdings. (For more information see, these asset allocation and diversification articles on The Skilled Investor website: You must stay invested in the securities markets to earn market risk premiums and Investment securities markets do not pay you for the risks of holding individual common stocks and bonds.)

The primary cash, bond-fixed income, and stock-equity financial asset classes have different expected investment risk and return characteristics. Financial asset allocation is the apportionment of your investment portfolio into one or more of these classes of market-traded financial assets. How you allocate major portions of your assets among the primary financial asset classes determines your portfolio’s overall exposure to investment risk and thus your potential for investment growth. (For more information on these subjects, see The Skilled Investor’s articles in these categories: Returns and Risk Premiums (10 articles) and Securities Valuation (4 articles))

You may encounter numerous industry approaches to gauging you investment risk tolerance relative to other investors. Caution may be in order, if someone asks you only a few risk questions or presents you with a similar very short questionnaire. Using your verbal or written responses, you quickly may be labeled a “conservative” or “aggressive investor.” However, investment risk tolerance is a much more personally and emotionally complex subject.

Assessing your personal investment risk tolerance is one of the most important personal investment decisions that you will make, because this decision drives the long-term risk-return composition of your investment portfolio. This decision requires much more personal and family introspection than is provided by trivial risk questionnaires. These short questionnaires often are just a front-end to a securities sales process. After answering a few questions, you may soon be blessed with a canned percentage asset allocation to the cash, bond, and stock asset classes, which supposedly matches the risk tolerance label that has been applied to you.

Once you are given a canned “conservative,” “aggressive” or other asset allocation, the investment sales process can proceed. The risk questionnaire helps to cover the securities vendor’s legal behind regarding investment “suitability.” In the next phase of the sales process, you may wish to watch out for selective investment recommendations that demonstrate superior historical returns. Recommendations may focus on investment funds that beat-the-market in the past, while the fund family’s laggard funds will not be mentioned. Recommendations may tend to have high costs and sales commissions. Simultaneously, there may be a dearth of investment recommendations that target a market return and have very low costs. (See this related article on The Skilled Investor website: “Pay less to get more,” which is one of our articles in this category: Controlling Investment Costs (15 articles). )

There are much more scientific methods to assess personal investment risk tolerance. For example, an Australian company, FinaMetrica, has developed a more extensive, and relatively inexpensive, personal risk tolerance assessment process. FinaMetrica’s approach seems to have some reasonable social science behind it. Furthermore, you can do your own assessment on-line without the involvement of a costly adviser.

FinaMetrica’s website is http://www.myrisktolerance.com/ Even if you do not wish to use their risk evaluations services, it is well worthwhile to explore the links in the left hand column of this website. FinaMetrica provides extensive written materials to help you understand personal financial risk tolerance and asset allocation. (Note that there is no business relationship between The Skilled Investor and FinaMetrica.)

Finally, when you determine your personal asset allocation, you may have other valuable personal assets to consider, such as real estate and private businesses. However, complications arise when these non-financial assets are factored into the mix with the primary cash, bond-fixed income, and stock-equities asset classes. For example, for most people who own any real estate, it is the net equity of their primary residence, after mortgage debt. Some of the net equity in the family home represents a long-term prepaid housing expense. They need somewhere to live the rest of their lives and would otherwise pay rent.

The remaining net equity in their home is a personal portfolio asset. Despite the banking industry’s current push to have people tap their home equity for vacations, pleasure, and other short-term consumption expenditures, those who recognize their possible very long life resist the urge to tap their home equity, except when no other alternative is available.

For people with who own just one piece of real estate, their primary asset allocation consideration might be simply to avoid loading up on more real estate in their portfolio in the same market that could be subject to similar economic forces and risks. Those who have more extensive real estate holdings may wish to select very carefully a reasonably priced adviser and get help in evaluating their asset allocation decision. (See these related adviser selection and payment articles on The Skilled Investor website: Selecting an Advisor (4 articles) and Payment of Advisors (11 articles). )