When it comes to investment risk, don't try and keep up with the Joneses

  • Risk is thought of as the potential downside on an investment, but there is a range of risks that need to be considered before determining a suitable portfolio of investments.
  • People's ability to take on risk is largely dependent upon the length of their investment horizon.
  • Don't invest solely based on stock market surges or "backyard barbecue" bragging about huge returns, warn advisors.

Are you a risk-taker? How much risk are you willing to take with your investment portfolio? Odds are, you don't have a very clear idea about either question.

"If you ask most people how much risk they want to take and how much volatility they're comfortable with, they'll scratch their heads," said Jay Welsford, senior vice-president at Connor Clark & Lunn Private Capital. "The concept of financial risk is not an easy one for clients to understand."

Risk
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It may not be easy to understand, but financial advisors consider the subject crucial to the effective management of client relationships. Unless advisors know what their clients' expectations are and how they will measure investing success, those clients will likely be disappointed.

"People think we're in the money management business but we're really in the risk management business," said Welsford, who has both individual and institutional clients.

Most people think of risk as the potential downside on an investment. But there is a broad range of risks that impact every investor to some degree, and which need to be considered before determining a suitable portfolio of investments.

Do you need income from the portfolio, or will you need to draw from it in the near future? If so, you have liquidity risk. Do you want to retire early? If so, you have longevity risk. Are you in the highest tax bracket? If so, you have tax risk.

"There's a checklist of risk factors for everyone, and we describe each risk relative to every client," said Welsford.

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The Merriam-Webster dictionary defines risk as the chance that an investment, such as a stock or commodity, will lose value. The greater the risk, the greater the potential loss of value.

Just how tolerant an investor is of losses, however, can be difficult to gauge — particularly if he or she has limited experience with investing. People may say they are un-phased by a 10 percent loss on their investments, and yet a $100,000 loss on their $1 million portfolios terrifies them.

Tim Maurer, director of personal finance at Buckingham and The BAM Alliance, looks at the issue of risk and risk tolerance from three angles: a client's ability to assume risk, willingness to assume risk and need to assume risk.

People's ability to take on risk is largely dependent upon the length of their investment horizon. Those in their 20s or 30s have a greater capacity to take risk and recover from large losses than someone approaching retirement. That's the concept underlying target date funds that allocate more assets to safer fixed income investments rather than riskier stocks as a retirement target date approaches.

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An investor's willingness to take risk is the most important factor in the equation, says Maurer. If large investment losses take a serious psychological toll on someone, he or she should not be in a high-risk portfolio.

"If a client was invested in the mid 2000's, I want to know how they felt in 2008," he said. Regardless of a client's financial circumstances, ability to cope with volatility and large losses is crucial to determining appropriate levels of risk to take.

"A lot of advisors try to solve this qualitative issue through quantitative meansm," said Maurer. "I want to give them the freedom to express their feelings about the issue."

The third factor Maurer considers is a client's need to take risk. That can be figured out largely by crunching numbers to determine what kind of return on assets a client needs to meet financial goals. "The purpose of investing is to meet your life goals," he said. "People may not need equity style returns [and risks] to meet those goals."

"There's a recency bias for people when it comes to investing. We exaggerate what we've experienced most recently." -Tim Maurer, director of personal finance, The BAM Alliance

Paul West, managing partner of Carson Wealth Management, uses a questionnaire with both new and existing clients to determine their investing expectations and their tolerance for risk. It involves just seven questions concerning a person's expectations for growth from investments, concerns, investment knowledge and attitudes towards risk and reward tradeoffs. People receive a score and a recommendation for a conservative, moderate or growth-oriented portfolio.

"In order to gauge someone's tolerance for risk and volatility, you need some quantitative measures," he said. The "risk tolerance" score serves as a starting point for a deeper discussion with clients about their financial goals and attitudes towards investing and risk.

"You have to apply art with science in this," West said. "A person can say they expect growth from their portfolio but maybe they also can't deal with a big drop in the market."

Making it more challenging is that people's attitudes towards risk change over time and in different markets. In good times, we forget the pain of the past and in bad times we're slow to seize opportunities.

"There's a recency bias for people when it comes to investing," said Maurer at The BAM Alliance. "We exaggerate what we've experienced most recently." Just as people were understandably scared to death of stocks in the first quarter of 2009, now they are perhaps irrationally looking to take on more risk as the bull market rolls on.

West of Carson Wealth Management blames some of this attitude on "backyard barbecue talk." When people hear that their neighbor earned 10 percent to 12 percent in the last six months versus their own 4 percent or 5 percent return, they question their financial plan.

"We tell them not to worry about the Joneses," said West. "The neighbors could be in debt up to their eyeballs.

"Maybe they have to take the risk," he added. "Our job is to be rational with our clients."

— By Andrew Osterland, special to CNBC.com

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