The Five Most Commonly-used Investment Risk Tolerance Categories
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The life factor that has the most influence on portfolio construction, the mix of asset classes someone should hold, and how risky they should be, is called their "investment risk tolerance."
This is why one of the first things most all financial advisors do is pull out some kind of an investment questionnaire to gauge how someone feels about losing their money.
Investment risk tolerance is known by many different names, but it's all the same thing. Some of the other names are: Investor risk tolerance, risk temperament, risk profile, investment profile, investor profile, investment profiler, investor profiler, risk attitudes, and investing risk tolerance. Investment risk tolerance is used in most of the CFA readings, so we're sticking with that.
Because none of this is an exact science, most investment managers work with three to seven risk categories. We use five because we feel three isn't enough and seven is too many.
These five categories are summaries of how the investor feels about investment risk, how much downside market fluctuations can be tolerated, and how much they expect to profit when markets are going up.
The biggest reason for needing to classify someone into a pre-defined category, is because most investment advisors use asset allocation models that correspond directly with each category. This is exactly what we do with our portfolio models. Once one is put into a category, an investment adviser can easily invest their money appropriately by using the corresponding model portfolio.
Our financial tool used to gauge an investor's risk tolerance category is called the Investment Fact Finder. It has multiple-choice questions that then feed both into a scoring section. Some clients like doing it on paper themselves, and there's also a spreadsheet that does this task semi-automatically.
The Five Investment Risk Categories in Detail
Conservative: This investor isnt willing to tolerate "noticeable downside market fluctuations," and is willing to forego most all significant upside potential, relative to the markets, to achieve this goal. In English, they really really don't want to get their monthly statement and see less money than they had before (unless it was due to withdrawals).
Most conservative investors want their portfolios to provide them with an inflation-adjusted income stream to pay their living expenses. They're either currently depending on their investments to give them a retirement paycheck, or are expecting this to happen soon. Some are on tight budgets and are barely making a living as it is, so they are very afraid of losing what little money they have left. They do not have time to recoup any losses (because they can't go back to work for a multitude of reasons). Some realize they don't need their portfolio to provide income for more than several years, because of low life expectancy, so growth is not the objective.
The majority of their money should be held in cash and high-quality short- and intermediate-maturity bonds. Very risky asset classes are typically avoided altogether.
Satisfying their needs is hard to achieve when inflation is high, or rising, because the market value of fixed income securities typically are declining due to increasing interest rates. So investing defensively is not without risk. There is no way to eliminate all risks when investing.
So the investments most desired by Conservative investors are the ones that lose the most value from inflation (e.g., fixed annuities). Investing defensively is not without risk, and there is no free lunch, nor a magic investment to solve one's problems, for anyone in investing (but our Conservative High-income Model is the closest thing to a magic solution to this dilemma as humanity will ever create).
In this case, the potential for the large loss of nominal dollars (how many dollars one has relative to how many they started with) is low, but the loss of real dollars (the inflation-adjusted worth of those dollars) is guaranteed. This is caused by the loss of purchasing power due to the prices of everything in their family budget going up.
Cash (savings accounts, money market funds, and CDs) most always lose real value over time because of the combined effect of taxes and inflation. There isn't much one can do if this happens, except to have exposure beforehand to asset classes that benefit when inflation increases (real estate and tangible / commodity-based mutual funds, like the precious metals and energy sectors). The catch is most of these are the same asset classes that are minimized, because they're "too risky," or don't provide a reasonable income yield.
Because Conservative investors are still "investing," they should have a higher return over most rolling three-year periods than investing 100% in money market funds, fixed annuities, CDs, and other bank instruments.
The typical range of annual returns in down financial markets are -3% to +1%, in flat markets 2% to 5%, and in up markets 6% to 8%.
Conservative portfolios produce the highest annual income yields - typically in the range of 4% to 7%.
Conservative portfolios produce very little capital gains distributions.
If an investor is so risk adverse that they cannot tolerate ANY downside risk to the nominal value of their money, then we recommend money market funds, or just putting their money in the bank.
We don't use an investor risk tolerance category for these ultra-conservative investors because we don't think these folks are investors in the first place. They have resigned to the fact that their real returns will be negative after considering taxes and inflation, and just care about not seeing the number of dollars they have decline. They should just hide it all in the safest vehicles possible. But not "under the mattress" because of its purchasing power will be substantially eroded from being 100% exposed to inflation.
Moderately Conservative: If a worried investor can tolerate a little more risk than the Conservative investor, but still is adverse to large short-term downside fluctuations, and wants a little more return with a little less income, then this is the category for them.
The typical investor in this category is either retired and getting their paycheck from portfolio income, soon to be retired, or has been burned by poor investment management and lost money in the past. These folks want to be protected somewhat from large downside market fluctuations and are willing to not fully-participate when markets rally upwards to get it.
Informed investors realize that if their life expectancy is more than a decade, then having exposure to investments that increase in value is needed to provide adequate income in the later years. These folks want to be protected somewhat from large downside market fluctuations and are willing to not fully participate when markets rally upwards to get it.
Their portfolio will still fall when the markets' decline, but they want to be somewhat protected from sudden double-digit percentage declines in their portfolios. They want to be in the game, but they are definitely playing defense. They also want to see low double-digit percentage gains when the financial markets are going up. This is achieved by having a significant exposure to fixed income securities, several different types of stocks, real estate, and commodities that track inflation. Core equity asset classes are used, but very risky asset classes are still held to a minimum.
Moderately Conservative portfolios produce significant annual income yields - typically in the range of 3% to 6%.
Moderately Conservative portfolios produce little capital gains distributions.
They are typically going to achieve returns a little more than taxes and inflation. When the major markets are increasing, they could realize double-digit returns. The typical range of annual returns in down financial markets are -6% to -2%, in flat markets 1% to 7%, and in up markets 8% to 11%.
Moderate: The majority of investors are in this middle-of-the-road category. The reasons for people to be in this category are too many to list here. The most-common is the desire to invest long-term for retirement or college funding.
These investors want good returns, and know they're taking some risk to get them. They should expect returns similar to a basket of similarly weighted market indices. Their portfolio should go up less than the markets as a whole, but should also go down less when markets go down.
A Moderate portfolio will hold a balanced mix of most all-major viable asset classes (for maximum diversification), which will include conservatively-managed bond funds as well as high-risk stock funds. This category typically uses the largest number of asset classes to both reduce risk and increase profits. Both safe and risky asset classes are utilized pragmatically. Balance between profits and loss reduction is the goal.
They know they will lose money if the markets go down, but also expect to be along for the ride if they go up.
Moderate portfolios produce modest annual income yields - typically in the range of 2% to 4%.
Moderate portfolios produce a moderate amount of capital gains distributions.
Moderate investment portfolios are usually compared to the S&P 500 to see how well they're doing. When the S&P 500 is going up, it should be up a little more than a Moderate investment portfolio (if it's very well managed). When the S&P 500 is down, the Moderate portfolio should be down less.
They are typically going to achieve returns greater than taxes and inflation. When the major markets are increasing, they could easily realize double-digit returns. The typical range of annual returns in down financial markets are -8% to -4%, in flat markets 4% to 8%, and in up markets 9% to 14%.
Moderately Aggressive: If an investor wants to outperform a basket of similarly weighted indices when the markets are up, and doesnt mind too much being down a little more than the markets when they are down, then this is the category for them.
They are taking on more downside risk than the markets, but expect to be substantially ahead of the game when markets go up. Fixed income positions are minimized and risky asset classes are fully utilized. Most of the bond and international stock mutual funds in this portfolio are aggressively-managed.
These investors want to take the risks of winning the game by playing hard offense, but still dont want to lose too much in a short period of time. Most Moderately Aggressive investors want to accumulate a significant amount of wealth in the future, are willing to wait a significant amount of time for the rewards (and to recoup short-term losses), and have a little income to contribute to the portfolio over time.
They know they will lose a high percentage of their money if the markets go down (more than the S&P 500), but also expect to profit greatly if they go up. More emphasis is put on making money than preventing the loss of money.
Moderately Aggressive portfolios produce the little annual income yields - typically in the range of 0.5% to 3%.
Moderately Aggressive portfolios produce a high amount of capital gains distributions.
They're typically going to achieve long-term returns far greater than taxes and inflation. When the major stock markets are increasing, they expect to realize double-digit returns. The typical range of annual returns in down financial markets are -10% to 0%, in flat markets -1% to 7%, and in up markets 10% to 15%.
Aggressive: Damn the torpedoes, full speed ahead! These investors want to substantially outperform the markets and (should) know they are exposed to much more risk than the markets. They could easily lose up to 40% of their portfolio value in a few months, and it may take years, if ever, to recoup these losses.
These investors typically hold mostly growth, small-cap, and sector mutual funds (or stocks or ETFs). Any fixed-income mutual funds in the portfolio are a small percentage of the portfolio, and also are of the riskier types that are aggressively-managed.
The purpose of any cash held is to handle any unexpected withdrawals, and to take advantage of perceived buying opportunities.
Aggressive investors are typically younger (The Invincibles), and intend to contribute relatively large amounts into the portfolio periodically over time.
Most aggressive investors either want to accumulate substantial wealth in the future, are in a hurry, have enough income from other sources to fund their living expenses, and/or have plenty of time to work and recoup losses. Some just may have not yet personally experienced significant losses in the markets, so their bravery usually ends up being their own downfall.
They should know they would lose a very high percentage of their money if the markets go down, but also expect to profit greatly if they go up. Most all emphasis is put on making money and little, other than the diversification benefits of using mutual funds with asset allocation, is used in preventing the loss of money.
Aggressive portfolios produce the little-to-no annual income yields - typically in the range of 0% to 1%.
Aggressive portfolios produce a very high amount of capital gains distributions.
They are typically going to achieve long-term returns far greater than taxes and inflation. When the major markets are increasing, they expect to realize large double-digit returns. The typical range of annual returns in down financial markets are -15% to -5%, in flat markets -3 to 7%, and in up markets 15% to 25%.
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