The Risky Approach to Risk Tolerance

I have to admit my frustration. I'm sorry to say this but I think the vast majority of people in the finance industry and the investor community have lost their minds.

I regularly hear comments from both of these sectors suggesting that when investing, people should invest according to their risk tolerance.

At first glance, there seems nothing wrong with that statement. And the more times you hear it, the more it appears to be conventional wisdom.

However, if you deeply analyse it, the flaws become apparent.

Why? What's wrong with investing in accordance to your risk tolerance or your risk profile?

Well the problem is this. It is your perception of risk. And it is your ignorance about what the real risk is.

That may sound a bit harsh, but sometimes you have to be blunt to smash through some of the long-promoted investing myths that are not really helping improve financial literacy levels.

The standard belief amongst the vast majority of investor community and financial professionals is this: If you're going to have sleepless nights because of the investments you/we have picked, then it's probably better for you/us to opt for something more conservative (safe), so you/we can sleep better and night and avoid the anxiety.

Excuse me? Did you just say that it is preferable to sleep well at night now, even though that means that you may not eat well in the future?

Well, that's what I heard anyway. Let me explain.

Ignoring the Bigger Risk

When most people talk about the risk associated with investing, they are only talking about one type of risk. The risk of losing a part of your capital or investment.

And, since no one really wants to lose their money, it makes sense to avoid the risk of investing in volatile investments such as shares, especially if you are nearing retirement or are already retired.

Except for one thing.

It completely fails to take into consideration the other risk. The bigger risk. The greatest risk to any retiree. Am I going to run out of money and is my money going to keep up with the cost of living?

For most pre-retirees and retirees that is a real risk. Therefore, any simple risk profiling exercise that only considers someone's tolerance to risk, but largely ignores their need and ability to take risk is grossly inefficient and negligent.

I acknowledge that pre-retirees and retirees face the sequencing risk and market risk associated with investing in equities. However, the answer is not risk avoidance but risk mitigation.

Strategies like having adequate cash reserves to cover three to five years of income needs, dollar cost averaging, diversification and quality individual shares with good franking credits can offset a lot of the risk that is associated with investing in shares.

If you invest only in accordance with your tolerance to risk (willingness), and don't consider your need and ability to take risk, you may face the very real prospect of running out of money. How? Because of the steady erosion of your purchasing power caused by inflation.

So investors, ask yourselves this: If you had a debilitating health condition, which doctor would you choose? The one who gives you the injection you need, or one who gives you a lolly instead because you don't like needles?

And here's one for finance professionals: next time your kids won't eat their greens or go to their piano lessons are you going to let them eat chocolate or play Nintendo? Or will you be tough with them knowing that this firm but caring stance is ultimately better for their well being?

Contact me today and let's talk.

 

The information provided in this article has been provided as general advice only. We have not considered your financial circumstances, needs or objectives and you should seek the assistance of a qualified Financial Adviser before you make any decision regarding any information, strategies or products mentioned in this communication. Whilst all care has been taken in the preparation of this material, no warranty is given in respect of the information provided and accordingly neither the author nor his related entities, employees or agents shall be liable on any ground whatsoever with respect to decisions or actions taken as a result of you acting upon such information.