Assessing Your Risk Tolerance - Personal Finance



Teaching Tool 16 - A Risk Tolerance TestPersonal Finance: Another Perspective2019IntroductionInvesting is a challenging topic. The key to investing is understanding the principles which should drive your investment decisions which we have discussed in class. They are know yourself; understand risk; stay diversified; invest low-cost and tax-efficiently; invest long-term; know what you invest in and who you invest with; monitor performance versus benchmarks; don’t waste too much time, energy and money trying to beat the market unless you have lots of time, energy, and money; invest only with high-quality individuals and institutions; and know your goals, budget, and have a well written investment plan that you follow. If you follow these principles in the planning, development, construction, and monitoring of your investments, there is a much greater chance that you will have a successful portfolio that will help you to reach your personal and investment goals. Know Yourself In the principles “knowing yourself and understanding risk,” it is important to understand how much risk you are willing to take. This is a difficult and time-consuming activity. To help you in this process, I have put together this risk tolerance test. There are lots of different risk tolerance tests available, and consider this as just one of many. Generally, firms will have their own test, with the goal of having you invest in their products. We have no biases here. The goal is only to help you understand yourself--we have no mutual funds or assets to sell.Creating your investment plan is affected by many different variables. Your emotional make-up plays a significant role. Intellectually, you may agree that stocks and bonds should be a major part of your portfolio. Emotionally, however, you may not be comfortable with the sometimes-wild ride of the stock and bond markets. Moreover, your income, your emergency fund, your current investments, your investment experience—all these have an impact on your willingness to tolerate risk. What should you do?Risk tolerance varies from one investor to the next. Indeed, two individuals with identical investment objectives, time frames, and financial resources may each have a very different willingness to tolerate risk. There is no simple scale to measure your tolerance (or intolerance) for risk. Likewise, there is no set of clear-cut terms which mean the same to all investors. Understanding Risk ToleranceDefining your personal risk tolerance level is important. It will allow you to build a portfolio that is the most suited to help you reach your future goals while allowing you to invest within your comfort zone, i.e. building a “sleep-well” portfolio. This short test may offer some insight as to your feelings toward risk. It will also rank some of the common factors that determine your ability to take on risk. These factors include age, income, current savings and general investment knowledge. Note however that this is just one test, and an imperfect one at that.Realize that there is no one-size-fits-all risk tolerance test. I have put the following test together to give you general guidelines to help you understand yourself and your tolerance for risk. I strongly suggest that you take a number of other risk tolerance tests, and compare the results with what you find here. It will likely be an eye-opening experience. Another purpose of this risk tolerance test is to help you as you work to determine your asset allocation targets for your investment plan.Your Goal: Asset AllocationThe purpose of this risk tolerance test, in addition to understanding your tolerance for risk, is to help you as you determine an asset allocation target that you can use for your investment plan. Realize that determining your asset allocation targets is one of the most important determinants of portfolio return, and as such, it should be done carefully. There is a three-step process for determining your asset allocation targets: (1) Determine your initial allocation between stocks and bonds (and cash). (2) Take a risk tolerance test, which will help you adjust that initial allocation consistent with your ability to tolerate risk. (3) Based on that risk tolerance test, make your final allocations of asset classes within stocks and your final allocation of asset classes within bonds and cash.Step 1. Determine your initial asset allocation. There is a general rule of thumb used in the financial planning industry that as an initial allocation for investing, you begin with your age in bonds. The logic is this: as investors get older, generally they will have less willingness to accept risk, and the higher bond allocation is representative of that lower risk level. Younger investor’s generally have a longer time horizon, and hence, can have a higher allocation to more risky asset classes, such as equities.Step 2. Take a risk tolerance test and adjust that initial allocation. Once that stock and bond initial allocation is determined, the next step is to adjust that bond allocation based on your individual risk tolerance. This risk tolerance test offers the second part of that allocation process. By taking this test, it can help you determine what your asset allocation should be based on your responses to each of the questions. The result of this risk tolerance test is an adjustment to that initial bond and stock allocation. Step 3. Allocate within each of the major asset classes: stocks, bonds and cash. The final step is to determine which asset classes within stocks (i.e. large capitalization, mid-cap, small-cap, International, Emerging Markets, REITs, hedge funds, etc.) should be included in your stock asset allocation, and which asset classes within bonds and cash (, i.e., government bonds (short- , medium- and long-term), corporate bonds (short-, intermediate-, long-term), junk bonds, etc.) should be included in your asset allocation targets.The general ideas and questions for this test were taken from the Arkansas Lawyer Magazine, Spring 2002 from the website: (k)_Spring02.htm. Risk Tolerance Questions:Age: What is your age?65 and over45 to 6435 to 4425 to 3424 and underThe younger you are generally, the more willing you should be to tolerate risk. If you are younger, you have a longer time horizon in which to grow assets. Generally, over the longer term, assets invested in the stock market have outperformed other asset classes. So if you are younger, should think about taking a little more risk. A general rule of thumb is that you should include bonds in your portfolio equal to your age.2. Time Horizon: What is your investment time horizon for this money?1. 1 year2. 2-5 years3. 5-10 years4. 10-20 years5. 20 years or longerWhile you will have different time horizons for different “buckets” of money, you should remember that money in the stock market is subject to more risks. Generally, if your time horizon is less than 3-5 years, it may not be a good idea to invest a sizeable amount in the stock market. You time horizon will have an impact on how much risk you are willing to take.3. Investment Goals: What is your primary objective for this money? 1. Preservation of Principal 2. Current Income 3. Growth and Income 4. Conservative Growth 5. Aggressive GrowthYour goals and budget seem to drive most areas of personal finance. Depending on your goals, it will make a big difference on where you invest your assets. If your goal is safety of principle, you should be willing to take on very little risk. Therefore, you should invest accordingly. If your goal is aggressive growth, you should be willing to take on much more risk. Your goals will to a degree, drive your willingness to take on risk.4. Personal Earnings: Regarding your current income, do you expect it to: 1. Decrease dramatically in the future 2. Decrease a slight amount in the future 3. Stay about the same 4. Increase with the pace of inflation 5. Increase dramaticallyYour income is an important driver of your investment program. If you feel your income will decline in the future, you will likely be much less willing to tolerate risk than if you think your income will increase dramatically. Your expectations of your earning ability will have an impact on your portfolio and risk.5. Emergency Fund: What amount of money do you have set aside for emergencies? This does not include borrowings or credit lines, but does include money in checking and savings accounts, CDs, money market funds, and assets in no-load open-end mutual funds that you can access quickly in case of an emergency.NoneEnough to cover three months of expensesEnough to cover six months of expensesEnough to cover nine months of expensesOver twelve months of expensesThe more money you have that can be used as an emergency fund, the more you are able to take on additional risk. Generally, with your first investments, you should take on very little risk. As your asset size increases, so should your willingness to increase your level of risk.6. Investment Experience: Which statement best describes your personal investment experience?1. I have never invested any money in any financial market or instrument.2. I am relatively new investor, having invested for only a few years.3. I have invested some of my money through IRAs and through employer sponsored retirement (401k, 403b) plans for quite some time, but now I am ready to develop additional investment strategies outside of that plan.4. I have invested for quite some time and am confident in my ability to make prudent investment decisions.5. I have invested money for years and have a definite knowledge of how the stock and bond financial markets work.Generally, the more experience investors have with the financial markets, the more risk they are able and willing to bear. However, this should be tempered by your willingness to accept risk.7. Investment Risk: Regarding your view of risk, which investment would you be more comfortable making? 1. I am comfortable investing in savings accounts, CDs, and other short-term financial instruments that are FDIC Insured. 2. I invest in savings accounts and CDs, but I also own various income-producing bonds and/or bond mutual funds. 3. I have invested in a broad array of stock and bond mutual funds, but only the highest quality.4. I have invested primarily in growth stocks and growth stock mutual funds.5. I like to pick out new and emerging growth companies and aggressive growth stock mutual funds.For most investors, a look at what they are invested in now may be a good indication of their willingness to take on risk. If they are invested only in CDs and other “safe” instruments, they are likely not willing to take on much risk. If they are investing in aggressive stocks and mutual funds, that indicates they are willing to take on much more risk.8. Investment Preferences: Which investment would you be more likely to invest in?1. This investment has a 20-year average annual return of 0-1%. It has achieved those returns with infrequent and very slight downturns. This investment has never experienced a negative return.2. This investment has a 20-year average annual return of 2-3%. It has achieved those returns with mostly positive returns, although there have been periods of less than a year of negative returns.3. This investment has a 20-year average annual return of 4-5%. It has achieved those returns with a few moderate downturns where the decline lasted less than six months and then began to recover. It has experienced more than one-year of negative returns.4. This investment has a 20-year average annual return of 6-7%. It has achieved those returns with several periods of above average returns and several periods of negative returns5. This investment has a 20-year average annual return of 8.0%. It has achieved those returns while cycling through several long periods of substantially above average returns and several long periods of substantially negative returns.Generally, higher returns require higher risk, which in this case is the possibility of having several years of negative returns. If you are comfortable with lower returns and lower chances for negative returns, you should position your portfolio accordingly. If you want the higher returns and are willing to take on the higher risk, likewise invest according to your willingness to accept risk.Your Risk ScoreStep 1. The initial asset allocation determination is the easiest, it is your age in bonds. If you are 25 years old, your beginning point would be your age in bonds or 25% in bonds. The remainder of your portfolio would be in equities. Step 2. The second step is to adjust your initial allocation based on the results of this risk tolerance test. To calculate your score, simply add up the points from each of the questions. You will receive one point for each number that you circled. For example, if you circled a 1 as an answer to question 1, you receive one point. If you circled a 4, you receive four points. Add all the points together from all the questions, and it will put you into a specific category, i.e. very conservative, conservative, moderate, aggressive, and very aggressive. As you see which category you are in, you will notice that below each category is an adjustment to that initial asset allocation. If your risk category is “Very Conservative”, you would notice that your adjustments to your initial allocation would to be increase bonds and cash by roughly 20%, and reduce your equities by 20%. At age 25 with this risk level, the results suggest an allocation of 45% bonds and 55% equities. At age 50, with this risk level, it suggests and allocation of 70% bonds and 30% equities. Notice that your age has a major impact on your allocations. Two different investors with different risk tolerances and ages could have the same allocations. For example an age 25 very conservative investor and an age 45 moderate investor would have the same allocations.Step 3. The final step is to review your “Risk Tolerance Category”, and with that knowledge, allocate between the various asset classes within stocks and within bonds. If you are “very conservative,” you would invest the majority of your allocations in the least risky asset classes within stocks, mainly large capitalization stocks. For purposes of diversification, you might have a small allocation, say 5 to 10% of your stock allocation to be invested each in small capitalization or international stocks. Likewise you would invest the majority of bond assets in the least risky categories of bonds, i.e. money market mutual funds, treasury securities, and corporate bonds.These questions and this scoring scale is not meant to be used for anything other than as a general guide to how much risk you are willing to take and to help you in your stocks versus bonds and cash allocation. Your actual investment plan may and should be based on additional information that was not asked in this questionnaire, as well as weighting information on which of the above questions are more important to you. While it is not exact, it may be helpful as you create a portfolio of investments that matches your asset allocation to your risk tolerance level. Risk Tolerance ResultsRisk Tolerance Category PointsAsset Classes: Adjustment to the initial asset class weights1. Very Conservative(8 to 12 points)Cash and bonds +20%Stocks -20%2. Conservative(13 to 20 points)Cash and bonds: +10%Stocks: -10%3. Moderate(21 to 28 points)Cash and bonds: 0%Stocks 0%4. Aggressive(29 to 36 points)Cash and bonds: -10%Stocks +10%5. Very Aggressive(37 to 40 points)Cash and bonds: -20%Stocks +20%* Investors are free to shift between the cash and bond allocations without any change in effectiveness of the test. I personally prefer to always have, at minimum, a 5% allocation to cash.DisclaimerThe purpose of this material and this class is to help you get your financial house inorder and to help you on your road to financial self-reliance. If there are mistakes in this material, please bring them to our attention, and we will correct them in upcoming versions. The teacher, and BYU, specifically disclaim any liability or responsibility for claims, loss, or risk incurred, directly or indirectly, by using this material. ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download