Why “risk tolerance” is misleading
A favorite phrase in the financial industry is “risk tolerance.” I even use it on my own website – I say “We need to pick the right financial tool for your specific goals, time horizon, and risk tolerance.” But what does it mean? If you wouldn’t go skydiving, should you avoid stocks?
The conventional wisdom is that a more risk-averse person should allocate their investment portfolio more conservatively than the average person. That is, if you can’t stomach the risks of stocks, buy more bonds to diversify and partially insulate your portfolio from big stock market drops.
Here is the problem – there are risks in every investment. And those risks change depending on your time horizon. In the short term, stocks are risky, and cash is safe. If your time horizon is long enough (multiple decades), cash is risky (inflation will eat away your purchasing power), and a diversified stock position is relatively safe! What then should a risk-averse person do? There is risk every way you turn!
The good news is that you can benefit from taking risk, if done properly. If you buy a diversified basket of stocks, you may experience a lot of volatility along the way, but history tells us your long-term returns will likely be very good. If you hold cash (or cash-like investments), you will likely lose purchasing power over the long run, but your capital will be very safe in the short term. The key, then, is matching your portfolio to your needs.
Of course, volatility is a type of risk. But my point is that there are many types of risk, and if you identify as risk-averse, then you need to consider all types of risk, not just volatility.
I would humbly like to propose a rebrand for “risk tolerance.” A risk-averse investor with a long time horizon should not avoid stocks – because inflation is a very real risk!
Instead, we should call it “volatility tolerance.” If you can’t stomach the volatility of stocks, and you won’t be able to stick with a stock-heavy portfolio through market downturns, then you shouldn’t be in stocks. Just know that you’re not avoiding all risk – you’re avoiding volatility, and you’re taking on inflation risk in order to do so.
I would be surprised if “volatility tolerance” replaces “risk tolerance” anytime soon. But I do think the distinction matters: you’re never going to eliminate risk from your financial life. The goal is to take the right risks for your circumstances.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
