Investment Risk Tolerance

Investment risk tolerance is the psychological component of investing. Ron Redfield, CPA, PFS, offers clear examples to shed light on investor psychology and investment risk tolerance.

Full Article - Table of Contents

Investment Portfolio Management
(What's important?)
Investment Term
(How long?)
Investment Risk Tolerance
(How risky?)
Investment Advice
(Our Recommendations)

Investment Risk Tolerance Examples

The investment risk tolerance of an investor is of major importance in investment portfolio management (along with consideration of investment term).

A major source of bad decision-making is the investor's misunderstanding of his own ability to absorb financial loss. In fact, we have seen that what investors think their investment risk tolerance is—and what their investment risk tolerance really is—are often two different things.

Here is an example.

During 1999 we had clients that felt our balanced portfolios were too conservative. They saw that their friends were making 30% investing in various mutual funds and tech stocks, while at the same time, they saw that their risk balanced portfolios (they had with us) were "only making 17%." They would claim that they could tolerate the loss of principal if the market were to give back some of its gains—expressing a high investment risk tolerance.

We often asked our clients the following: "Can you afford to lose 50% of your portfolio?"

Very often a client thought they could psychologically tolerate such a loss, but in reality they could not financially afford such a loss.

Keep in mind that the NASDAQ lost in excess of 75% of its value from its March 2000 highs of 5048.62 on March 10, 2000. The NASDAQ closed at 1907.85 on October 7 2003. The year to date gain of the NASDAQ through October 8, 2003 is 42.86%.

Let's put this into perspective, using another example.

An investor (let's call him Johnny Jones) invests $100,000 into the NASDAQ on March 10, 2000. Johnny claims to be a long-term investor with high investment risk tolerance.

On October 9, 2002, over 2 years after the original investment was made, with the NASDAQ at 1114.11, the original investment is worth $22,067. Yet, the markets have bounced back strong so far in 2003 and the original $100,000 investment is now worth $37,746, with the NASDAQ being at 1907.85. Johnny is no longer losing 78% of his original investment; his losses are down to only a 62.25% loss.

This happened during a period of 3 ½ years, and one really has to explore whether Johnny was truly an investor who was psychologically able to tolerate massive losses.

So, what is an investor supposed to do? How does an investor determine if they should be in pure safety—or if they should have an emphasis on a more aggressive portfolio?

Let's take a look at some investment advice, which we give to our own clients that wonder about investment risk tolerance.

About the Author

Ronald R. Redfield, CPA, PFS, is available for a free consultation and sample portfolio based on your investment risk tolerance levels. And you're warmly invited to request a complementary copy of Ron's text on investment philosophy.

Please contact Ron by visiting him at Redfield, Blonsky & Co., sending him an email, or calling him at 1 (908) 276-7226. Be sure and read Ron's latest commentary on financial investments, to keep up with market changes.