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Have you considered your financial and emotional capacity for risk?

There’s a saying at Innova Wealth Partners that “if you don’t know your risk tolerance, the market will teach it to you”. Unfortunately, over the last few months, many investors were taught by an unforgiving teacher! There hasn’t been as significant a test of our investment resolve in the last decade, so I think now is a great time to review the elements of our ability to handle risk. In this post, we’re going to explore the two key elements for you to consider while investing.

First, we’ll start by looking at someone’s financial capacity for risk with an example. Our investor, John, knows that he will need $20,000 a year from his portfolio to make up the difference between his Social Security benefit and his living expenses over the next 30 years in retirement. John was a prudent saver and has a retirement account of $2,000,000. Armed with just this information, we can confidently say that John has a high financial risk capacity. Our financial risk capacity is strictly based on our money’s ability to bear risk and to figure this out, we only need a few pieces of information; how much money we have, how much money we’ll need, and how long until we need it. In our example, since John is only withdrawing 1% ($20,000/$2,000,000) of his portfolio per year, even a drop in portfolio value of 50% would have very little financial impact on his retirement outlook. If his account fell to $1,000,000, his $20,000 a year in income need would still only equate to 2% of his portfolio! This remains a very sustainable amount even by the conservative estimates. If this were our only metric to measure John’s ability to bear risk, a highly volatile portfolio could be considered a reasonable option for him.

John’s emotional capacity for risk comes from a very different place than his financial capacity. As we saw in our very simple example, financial capacity for risk is a product of mathematics. His emotional capacity, however, has developed over years of life experiences. Suppose John had been hit particularly hard during the great recession or he had witnessed someone close to him lose their entire nest egg on speculative investments. Events like these have a very real emotional impact on us and change the way we are able to cope with volatility in our portfolio. Having experienced these events, John is very nervous of the stock market and knows himself well enough that when asked how he would handle even a 10% drop in his portfolio, he would immediately liquidate his investments, take the cash, and stick it under his mattress. With this information, we would say that John has a very low emotional capacity for risk.

So what are we to do with these two types of risk assessments? If John only considers his financial capacity for risk and ignores his emotional capacity for risk, chances are very high that he will end up in a portfolio that will keep him up at night! Sure, it may be almost a certainty that even a large drop in John’s portfolio value will have little impact on his retirement but just the thought of losing his hard-earned money causes him to live in constant fear. This fear could cause John to make drastic changes midway through his plan that very well may be detrimental. Therefore, considering both aspects of our capacity for risk is a necessity and the way to manage the two is through the financial planning process.

Going through the financial planning process is one of the most important things we can do in relation to investing. It gives us our roadmap that we’ll use as the base to all of our future decisions. Through a financial plan, we discover the return necessary to support our goals in retirement. With that knowledge in hand, we’re given a much clearer picture of how much risk we must take to achieve our goals. The goal of the plan is to find the intersection of how much risk we are both ABLE (financial risk capacity) and WILLING (emotional risk capacity) to take, and our objectives. By considering and balancing the two, you gain the confidence that not only will your portfolio provide for you and your goals, but that you’ll also be able to emotionally handle the volatility inherent to investing.  We’ve found that having a robust and durable financial plan is the single best way to help us stay on track when we feel ourselves wavering in the face of market turmoil like we’re witnessing today.

At Innova Wealth Partners, we specialize in creating and walking our clients through a financial plan that both achieves their financial goals while giving them the confidence that they will be able to weather the storms along the way. Remember, the best plan is one you can stick to!

Let us know if you’d like help developing your own financial plan or if you would like to discuss how your financial and emotional capacity for risk has affected you or changed during these volatile times.

 

 

Innova Wealth Partners, LLC (“Innova”) is a registered investment advisor. Information presented herein is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. 

 

Readers of the information contained on these performance reports, should be aware that any action taken by the viewer/reader based on this information is taken at their own risk. This information does not address individual situations and should not be construed or viewed as any typed of individual or group recommendation. Be sure to first consult with a qualified financial adviser, tax professional, and/or legal counsel before implementing any securities, investments, or investment strategies discussed.

  

Any tax information and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Innova does not provide legal or tax advice. Innova cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Innova makes no warranties with regard to such information or results obtained by its use. Innova disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.

 

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