Investment Portfolio Design: Determining Your Risk Tolerance
Investment success is generally not a result of catching a ride on a hot stock, nor is the achievement of one’s financial goals contingent upon buying the right mutual fund before it rises to the top of the rankings. Certainly, investors would rather hire good managers than poor ones, but their ultimate ability to achieve their financial goals is much less dependent upon that factor than many believe.
While the specific investments comprising a portfolio are an important element, their significance should not be overstated. The starting point for developing an appropriate investment plan is the analysis of one’s current personal financial position. Consideration of the individual’s goals, tolerance for risk, capacity for future savings, current and expected future income, and tax circumstances are all critical matters to be contemplated at the beginning of the portfolio construction process. The effect of each should be incorporated into the plan if it’s to have a high probability of success. Determination of these variables will not only assist in the development of the investment plan itself but will also help to identify the types of investments that are appropriate for inclusion in the portfolio and those that aren’t.
During the portfolio design process, the investor should gain a thorough understanding of the risks involved with investing in a range of investment options. The history of the capital markets provides excellent insight into the volatility of fixed income and equity investments and their potential for gain or loss over short and long periods of time. Well-informed investors should structure their portfolios in a manner that would not allow them to assume more risk than they can bear. A proper asset allocation should position the investor to weather the inevitable storm, riding out any short-term losses while maintaining a long term perspective. Nonetheless, investors also need to allocate a sufficient portion of their portfolios to more aggressive investments to have a high probability of achieving their stated goals. If their tolerance for risk cannot be balanced with the risk required to achieve success, the investor’s goals may not be attainable, and expectations must be reined in.
Once that asset allocation plan has been determined, it should be formalized in a written Investment Policy Statement (IPS). Upon implementation, the IPS provides the guidelines for the management of the investment portfolio over the long term. It outlines expectations not only for investors but also for the investment consultant and any money managers. Moreover, the quantifiable parameters included in the IPS should assist investors in managing their own expectations. While many investors don’t develop a formal IPS, it’s essential to the effective management of the portfolio. By formally acknowledging the potential range of returns, potential market risks, and reasonable long term returns prior to implementation, investors should be better prepared to adhere to their long term strategies rather than moving to a more conservative portfolio when markets become unsettled, and to resist the temptation to become more aggressive during periods of strong equity returns.
Only after finalizing the IPS should investors consider hiring specific money managers or purchasing mutual funds. Making decisions about specific investments prior to this point would be premature. Even after implementation, a portfolio should be monitored on a continual basis. The dynamic nature of the capital markets may create opportunities or hold greater risk in individual segments of the market over time. Further, investment management firms are dynamic organizations; the investor cannot assume that a well-managed mutual fund or separate account product will remain a winner indefinitely. In this way, the design process is constantly being revisited, and the portfolio can be modified as necessary.
While the specific investments comprising a portfolio are an important element, their significance should not be overstated. The starting point for developing an appropriate investment plan is the analysis of one’s current personal financial position. Consideration of the individual’s goals, tolerance for risk, capacity for future savings, current and expected future income, and tax circumstances are all critical matters to be contemplated at the beginning of the portfolio construction process. The effect of each should be incorporated into the plan if it’s to have a high probability of success. Determination of these variables will not only assist in the development of the investment plan itself but will also help to identify the types of investments that are appropriate for inclusion in the portfolio and those that aren’t.
Assessing Risk Tolerance
Only after evaluating these issues should steps be taken to design the optimal portfolio. Connecting financial goals to current resources will almost always require the investor to take risks by holding some combination of investments (e.g., stocks, bonds, alternatives). The balance between investment vehicles should be a function of the investor’s tolerance for risk and their financial goals. The more aggressive the goals relative to the current financial position, the more risk is likely necessary to achieve success. This generally results in a higher allocation to more volatile holdings such as stocks in the portfolio. Conversely, individuals may also find that they’re well-positioned to reach their goals, suggesting that less risk, and a correspondingly lower allocation to more aggressive alternatives, is necessary.During the portfolio design process, the investor should gain a thorough understanding of the risks involved with investing in a range of investment options. The history of the capital markets provides excellent insight into the volatility of fixed income and equity investments and their potential for gain or loss over short and long periods of time. Well-informed investors should structure their portfolios in a manner that would not allow them to assume more risk than they can bear. A proper asset allocation should position the investor to weather the inevitable storm, riding out any short-term losses while maintaining a long term perspective. Nonetheless, investors also need to allocate a sufficient portion of their portfolios to more aggressive investments to have a high probability of achieving their stated goals. If their tolerance for risk cannot be balanced with the risk required to achieve success, the investor’s goals may not be attainable, and expectations must be reined in.
The Importance of an IPS
Once that asset allocation plan has been determined, it should be formalized in a written Investment Policy Statement (IPS). Upon implementation, the IPS provides the guidelines for the management of the investment portfolio over the long term. It outlines expectations not only for investors but also for the investment consultant and any money managers. Moreover, the quantifiable parameters included in the IPS should assist investors in managing their own expectations. While many investors don’t develop a formal IPS, it’s essential to the effective management of the portfolio. By formally acknowledging the potential range of returns, potential market risks, and reasonable long term returns prior to implementation, investors should be better prepared to adhere to their long term strategies rather than moving to a more conservative portfolio when markets become unsettled, and to resist the temptation to become more aggressive during periods of strong equity returns.
Only after finalizing the IPS should investors consider hiring specific money managers or purchasing mutual funds. Making decisions about specific investments prior to this point would be premature. Even after implementation, a portfolio should be monitored on a continual basis. The dynamic nature of the capital markets may create opportunities or hold greater risk in individual segments of the market over time. Further, investment management firms are dynamic organizations; the investor cannot assume that a well-managed mutual fund or separate account product will remain a winner indefinitely. In this way, the design process is constantly being revisited, and the portfolio can be modified as necessary.
