We spend a lot of time exploring our client’s need versus ability to take risk – two very different concepts. In this case, the risk I’m referring to is that associated with the potential for a decline in value of a portfolio due to exposure to the equity markets, often thought of as volatility.
The need to assume risk in your investment portfolio is often driven by the numbers. In preparing your financial plan, you have spent time identifying your expenses; have been reasonable in projecting your sources of income and the amount you can save. Now the question is what return is required to make the plan work?
Your ability to take risk is another matter entirely. It is emotionally based rather than numbers based. Think about these questions:
Obviously, if the need is higher than the ability to take risk, something has to give. Adding a higher equity allocation to your portfolio could be a recipe for disaster. A more severe decline in value could lead to that fateful decision to pull out of the equity markets entirely, only to miss the recovery because you can’t decide on right time to go back in. Adjustments to other variables of the plan – usually spending or length of time to work – would be needed for the plan to be successful.
If the numbers say that your plan will work with an asset mix of 60% fixed income and 40% equity, yet you have always held 75% equity, should you pare back? We have had clients in this position who decided to reduce their risk, rather than continue to hold a higher equity allocation.
In either case, it is still imperative to monitor the plan – it remains as important as ever to ensure you stay on track.
The need versus ability to take on investment risk - yet another example of the art and the science of wealth management.