An investor’s risk tolerance is a function of a few key considerations. The most important among them are the investor’s investment time horizon and liquidity needs. The investment time horizon, or how long the investor expects to remain invested before requiring liquidity from their portfolio to fund their objectives, such as funding college, purchasing a house, providing retirement income or, in the case of institutions, funding operating needs, capital projects, grants and scholarships. The longer the time horizon and the lower the need for current liquidity, the higher the ability to assume risk.
In addition to the basic determinants of an investor’s ability to assume risk, their willingness to tolerate potentially extreme market volatility is not as easily defined. Misjudging an investor’s risk tolerance may lead to making poorly-timed, emotional portfolio reallocations and significantly impairing long-term returns in the process.
Studies conducted have shown that the average investor’s returns have annualized 2.5% over the 20-year time frame from 1999-2019, despite annualized returns of 6.1% for the S&P 500 and 5.6% for a 60/40 portfolio over the same time frame. This is primarily due to the average investor’s decisions to inappropriately reallocate their portfolio on a reactionary basis during extreme market conditions, thereby significantly damaging portfolio returns in the process, i.e. buying high and selling low. Understanding an individual’s risk tolerance and structuring a portfolio with the appropriate asset allocation before volatility flares up should prevent this outcome.
Source: Dalbar Inc., JP Morgan
Establishing a well-defined investment strategy and understanding the need to stick to a long-term plan can help investors stay on track when markets become challenging. An important part of an investment strategy generally includes a well-diversified equity allocation, given the superior total return potential over long periods of time. Along with the higher return potential, investors should not lose sight of the inherent volatility associated with equity investing, and not be thrown off course when market volatility heats up, as is frequently the case.
Source: FactSet, Standard & Poor's, J.P. Morgan Asset Management
As depicted in the chart above, the S&P 500 has generated positive calendar year returns in 30 of the last 40 years notwithstanding the associated volatility. The chart below demonstrates the perils of market timing and the damaging effect on long-term rates of return.
Source: JP Morgan
Maintaining a disciplined approach and a long-term perspective is critical for investors to achieve their long-term investment goals. The client’s advisory team should gain a comprehensive understanding of their total financial picture and risk tolerance before customizing a plan to meet their financial objectives. Once an investment plan is created, it is important to review and revise it regularly as an individual’s financial circumstances along with risk tolerance may change and evolve over time. Changes to an investor’s financial situation may also require an adjustment to the investment plan and portfolio asset allocation to reflect the new considerations. It is important for investors to discuss any expected changes to their short- or long-term objectives with their advisors in a timely manner so that portfolio adjustments can be managed accordingly.
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