An asset allocation is designed to produce long term results, within an acceptable level of risk. Such strategy should remain consistent whether the market is relatively stable, volatile, increasing or decreasing. Asset allocation strategy should not be changed due to market circumstances, but that doesn’t mean that there aren’t times when it is both appropriate and advisable to update your strategy. A change to your risk tolerance or return needs would indicate that it is worth revisiting whether an update to the asset allocation of your portfolio is needed.
Behavioral finance scientists have found that generally your risk tolerance doesn’t change much over time.
Risk tolerance is more of a personal trait than anything, but what can change dramatically over one’s life is risk capacity or the ability for one to take on more financial risk. Thus, it is very possible that your risk tolerance might increase over time. Such factors that might increase your appetite for risk can include the following:
- A need for increased return to better satisfy your goals
- An accumulation of value in your residence and/or investment assets which allow you to tolerate more risk
- The general emotional ability to accept volatility
Your risk tolerance might decrease as well because of certain factors such as the following:
- Lower return needs
- Uncertainty of future income
- Less emotional ability to accept volatility
As an investor continues to engage in financial planning, they might conclude that their return needs are different than the last time they checked.
The requirement of higher return needs might lead to the need to assume higher risk. Here are a few reasons you may conclude that higher returns are needed:
- Lower returns on current investments than originally planned for
- Less business earnings or compensation than anticipated
- Increased lifestyle
- Higher retirement needs than originally projected
- Retirement sooner than anticipated
On the contrary, investment return needs might be lower due to many different factors, which can include the following:
- The success of career and anticipated earnings
- Accumulation of personal savings and investments
- Ability and desire for delayed retirement
When you discover a change to your risk capacity or return necessity, it might be time to update your asset allocation strategy. Finding an “intersection” between desired risk and return is of utmost importance.
If the desired return is higher than the maximum tolerable risk level, the investor must make some difficult decisions that will involve either accepting a lower return or a higher risk level. Some questions to ask are as follows:
- Should my goals be modified?
- Should other earnings be increased?
- Should a higher risk level be accepted?
These scenarios can play out in many ways, but here is one such example. Michael and Mary are both 45 years old. They are chiropractors who have been earning money and saving for the last 20 years. Since they were young and ambitious, Michael and Mary had an investment allocation of 80 percent equities and 20 percent bonds. Their portfolio has grown steadily, but due to market downturns, they find that their goal of retiring at age 50 may not be attainable. To earn a higher rate of return, Michael and Mary would have to accept a higher level of risk, which they are unwilling to do. Thus, they decide to continue to work until age 55, to ensure a comfortable lifestyle during retirement.
Effectively, Michael and Mary found that there was not an “intersection” between their desired return and acceptable risk level. Rather than accept a higher level of risk or increase earnings (which they determined was not possible), they decided to modify their retirement goal. By delaying retirement, Michael and Mary were able to lower their investment return needs and retain their current asset allocation strategy.
Once the updated asset allocation strategy is determined, it must be compared to the current allocation. In most cases, portions of the current allocation will require decreases while other portions will need to be increased. However, prior to selling current positions, consideration should be given to tax impacts and transaction costs. If the costs of reallocation are high, an alternative approach might be to gradually shift the allocation as the investments shift or as other funds are added.
Your risk tolerance and your return needs would ideally go hand in hand, but this is by no means a given.
Ideally, the amount of risk you can stomach should align with the risk that is needed to get the returns to achieve your goals. However, it is rarely the case that these coincide perfectly and often concessions might need to be made as seen in the previous example. This is truly a process of self-discovery that is meant to evolve over time. As part of the financial planning process we regularly ask clients to update goals and encourage clients to reevaluate their risk tolerance. In doing so, we try to continually ensure that our clients are invested appropriately for both their emotional ability and their current financial situation