Accessing Portfolio Risk

Tim Obendorf |

When building a portfolio with the right amount of risk, we  look at three factors: risk tolerance, the amount of risk needed to achieve financial goals and the financial capacity to take on risk.  To measure risk tolerance, we use a tool called Riskalyze, which asks a series of tradeoff questions to determine how sensitive you are to losses compared to gains.  At the end of the questionnaire, Riskalyze assigns a score ranging from 0 (very risk averse) to 99 (highly risk tolerant).  Risk tolerance gives us a starting point to make sure we don’t recommend a portfolio way outside your comfort zone.  The worst scenario is to have you panic when the market drops and sell your investments at the bottom because you weren’t comfortable with the risk. 

The second factor we analyze is your need for risk.  It’s not always the most risky or, alternately, the safest portfolio that will help you meet your financial goals.  To assess your need for risk, we run Monte Carlo scenarios to determine the risk needed in your portfolio to help you meet your financial goals with high confidence.  Our Monte Carlo simulator runs 1000 iterations using different portfolio returns based on your portfolio risk level. The analysis estimates the probability that you will have enough money to achieve your goals. By adjusting your portfolio risk level, we can estimate which portfolios are likely to generate enough growth and income to meet your financial needs. Generally, we look for 90% of scenarios to be successful.

Finally, we review your overall financial position to see how higher or lower risk portfolios will impact your overall financial wellbeing.  This includes a review of your other assets and liabilities, your current and future income and the timing of your financial goals. 

Once we determine an appropriate risk level, we create an Investment Policy Statement, which acts as a blue print to guide future portfolio decisions.  It’s like a battle plan you create before the battle begins.  Behavioral economics tells us that decisions made in a highly charged emotional environment are, more often than not, bad decisions.  This is because most of us experience a recency bias:  if markets have been going down, we assume they will continue to go down, and if markets have been going up, we assume that they will continue to go up. It’s hard to see the bigger picture “in the moment.” Developing a thoughtful investment policy ahead of time helps us make better decisions during stressful (or euphoric) times when markets are moving fast.

If you'd like to evaluate your risk tolerance feel free to contact us for a complimentary consultation.