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Risk tolerance is a blind spot for ‘accidental’ investors

Whether investors are saving for retirement, a college education for their kids or their first home, it's never been more important for them to have a strategic understanding of risk tolerance in order to meet their goals.

This is magnified when you consider that many households have become investors by "accident" or are saving for retirement via their employer's 401(k) plan, with little or no financial training.

For those with retirement in mind and a far shorter runway from which to build wealth — or rebuild it, in the event of an unexpected downturn — it's only that much more critical to have a view into the different scenarios that could alter both their near- and intermediate-term plans.

Roulette wheel risk speculation
Mbbirdy | Getty Images

Thirty years ago investing was all about simply chasing return. But back then, investing was mainly for the rich to make more money. Today, because of the advent of the 401(k) plan, most of the investors in the United States are saving for their retirement. This places an added emphasis on risk within the context of achieving gains instead of simply chasing gains.

Risk now becomes the controlling factor in portfolio selection: Too much of it and you could suffer a debilitating loss; too little and you may not get the growth you need to achieve your goals. Assessing one's appetite for risk is, therefore, one of the most important things an investor needs to get right from the beginning.

These accidental investors, who've grown their wealth through employer-sponsored plans, in most cases have taken a disengaged approach to investment selection and have very little real sense of the amount of risk that's present in their portfolios at any given time.

This matters little when the market rises for seven consecutive years, but it's an issue that is now front and center as the baby boomer generation hits retirement age just as the global markets assume a far more volatile posture.

To be sure, the markets have been breeding anxiety since the outset of 2016, yet no one really knows if this is the start of the "third wave' of the financial crisis or if we're about to see a sustained global economic recovery.

Professional pundits and prognosticators speculate daily on whether investors should be reducing market exposure to protect themselves from aggressive deflation, or buying risk assets, such as stocks, to capitalize on an emerging markets rebound.

"In today's 'zero-interest-rate environment,' there's no way to avoid investing in 'riskier' assets, such as equities, if the objective is to grow wealth."

The huge swings we've seen this year have even caught professional hedge-fund managers on the hop. So what chance do ordinary savers with no financial training have when they're making potentially life-changing investment decisions in their 401(k) plan accounts?

The good news in this era of transparency and simplified financial solutions is that tools are available to anyone who wants to create or validate a long-term investment strategy tailored to their individual risk tolerance and plan to stick to it.

As an investor, it's critical to understand the nature and level of the market risks and how these risks can alter or impede long-term financial goals. Those who understand their risk can better stomach market losses without panicking or selling at the worst possible time.

Those who got out of equities in 2008, for instance, would have missed a rebound that more than made up for the pain suffered in the months after Lehman Brothers fell. Moreover, those who understand their risk are less likely to put all their eggs in one basket in an attempt to maximize the growth potential of their 401(k) plan or individual retirement account.

Of course, in today's "zero-interest-rate environment," there's no way to avoid investing in "riskier" assets, such as equities, if the objective is to grow wealth.

And that means that most savers will likely have to ride out one or two stock market crashes before they retire. The important thing is to ensure that these downturns don't take such a big toll on their life savings that they will be forced to delay retirement or put it off altogether.

Retail investors should assess, with their advisors' help, their risk tolerance and gauge how much risk to take on. Then they should rebalance their portfolios accordingly.

Too often, these accidental investors get caught in an endless cycle of rash decision-making driven by headline noise. The markets are crashing, so they sell at the lows; the market is overbought, and investors jump back into the market at its peak.

Rather than be reactive, investors and their advisors should evaluate what level of risk is appropriate and then examine how an investment portfolio aligned to that risk profile (such as aggressive, moderate or conservative) would perform under different market scenarios.

Seeing just how much money they would lose if and when the next crash happens, and whether that portfolio has enough potential for upside gains to provide a comfortable retirement, will lead to better-informed decisions.

This sort of exercise is an improvement on the complicated psychometric questionnaires that many advisory firms use to understand their clients' risk tolerance. By utilizing analytics and a historical perspective that clearly defines the risk versus the reward of any investment, investors will be better suited to make the right choices.

Advisors stand to gain by strengthening their relationships with existing clients and by gaining referrals from satisfied investors.

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As an increasing number of Americans saving for retirement turn to low-cost passive solutions, they need to make sure their portfolios have been selected with their investment goals in mind, in strict alignment with their risk tolerance.

By assessing their risk tolerance, stress testing their portfolios for different environments and rebalancing their investments in accordance with their goals, investors stand an actual chance of realizing their retirement goals rather than arriving at the finish line by accident or chance.

— By Kendrick Wakeman, founder and CEO of FinMason