As the above example illustrates, your tolerance for risk doesn’t speak to your ability to assume risk, and that ability changes dramatically as we approach retirement. Determining an individual investor’s ability to abide risk is where many professional advisors are helpless. One’s ability to assume or tolerate investment risk is quantitative. It is based on factors like the present and future income need versus present and future expenses, amount of income in excess of costs, rate of saving, net worth, investment time horizon, and specified financial objectives, among other quantifiable facts.
Typically, a better capacity to tolerate risk is associated with longer investment time horizons, recurring incomes in excess of expenses, and higher amounts of assets and/or anticipated assets in excess of expected present and future needs. These circumstances are linked with the ability to tolerate risk because they are thought to contribute to relative insulation from the effects of numerous gradations of investment risk on an investor’s overall financial condition.
Due to the earlier stated idea that bigger investment risks can accompany greater potential returns, professional advisors sometimes fall victim to an insistence that, because one is quantifiably able to assume investment risk, they should undertake as much investment risk as their circumstances permit. For some investors, assuming as much investment risk as they are able will be the right call. For others, it is entirely inappropriate.
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Last Updated: 6/25/2018
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