Investing for Physicians: Determining Risk Tolerance
Many of the early planning steps in the life of a physician are rather dull. I mean, establishing an emergency fund and getting life and disability insurance don’t exactly get the heart racing. But once the very important (and boring) defensive planning is in place, financial planning starts to become . . . fun.
Well, maybe for some people. But in any case, most people would much rather discuss investing for the future than planning for the bad things that can happen to us in life. In this series, I’m going to explore the important steps that the physician should take in order to create a sound investment strategy.
Arguably the first item that you’ll need to determine as an investor is what amount of risk are you willing to take. But what does this actually mean, and how do we do it? Understanding yourself and truly how much you are able to bear in a fluctuating market is extremely important.
What does “risk tolerance” mean?
Let’s begin by defining some terms. Risk tolerance is the process whereby an investor determines how much fluctuation they expect to be able to withstand. You might think of this as “the sleep well at night test.”
For example, I once worked with an individual with a sizable portfolio. He and his wife were more elderly and it wasn’t likely that they were going to be running out of money during their lifetime. Unfortunately, this gentleman was in the habit of checking and fretting over his portfolio balance. With the natural ups and downs of the market, he was calling into the office to get reassurance rather regularly.
This eventually led our team to recommend that he reduce the amount of stocks, and increase the amount of bonds, in his portfolio. For investors interested in leveling off some of the ups and downs of the market, reducing your stock allocation can help. The downside of this action, of course, is that by reducing “risk,” one is also reducing the likelihood for greater future returns. More on this later, and in a separate article.
Essentially, risk tolerance allows you to determine your asset allocation, or the ratio of stocks and bonds in your investment portfolio. Stocks are inherently “riskier” assets, so the greater percentage of them in your portfolio, the greater your risk tolerance should be. Over the long run, many investors believe that you are compensated for a higher stock allocation (higher risk) by also benefiting from higher returns.
Though this may sound like a simple exercise, it is a very important one. For example, having a properly adjusted portfolio according to your risk tolerance can mean the difference between you riding out a down market, and selling all your assets and moving everything to cash—a catastrophic move that many investors have made in the past when the market fluctuates greater than they can withstand.
Determining your risk tolerance.
Risk tolerance is often determined by financial advisors through a risk tolerance questionnaire. For investors wanting to get an idea of their risk tolerance on their own, Vanguard has an online questionnaire that you can access here. Questionnaires differ somewhat from firm to firm, but they are all driving at the same object—how should your portfolio be constructed in order to achieve maximum returns, while also taking into account constraints imposed by your emotional well-being.
Here are a few sample questions that you might see on such a questionnaire:
When you think of the word 'risk', which of the following words comes to mind first?
You are on a TV game show and can choose one of the following. Which would you take?
$1,000 in cash
A 50% chance at winning $5,000
A 25% chance at winning $10,000
A 5% chance at winning $100,000
In terms of experience, how comfortable are you investing in stocks or stock mutual funds?
Not at all comfortable
The basic concept is to get an idea of how much market volatility (ups and downs) you can tolerate.
In recent years there has been a trend toward so-called “target-date funds” that adjust the ratio of stocks and bonds as you age. The older you get, the greater the percentage of bonds within the portfolio. While it is generally true that one seeks greater security with age (and as one gets closer to retirement), I’m cautious about blindly accepting the target date fund allocation, or other similar rules of thumb that base your stock to bond ratio on your age.
I believe that a better approach is to understand your personal comfort with “risk” and construct a portfolio that meets your unique need for comfort, as well as investment performance.
To be fair, if you plan on never monitoring your portfolio, then I suppose the target-date-fund can be a reasonable solution.
Balancing returns with risk.
Some time ago I was working with an individual who was very close to retirement. As we discussed his forward-looking returns, he expressed concern that the estimated future returns looked too low. He remarked that if better returns couldn’t be achieved, he should just take his business elsewhere. I considered his point and told him that one can seek higher returns, but not without additional risk.
And that’s one of the great truths of investing, in my opinion. Taking additional risk provides the opportunity for greater returns. But as in life, with investing there are no guarantees.
Be skeptical of investments that promise great returns with “no risk” or little risk. It just doesn’t work that way. The purpose of determining one’s risk tolerance, therefore, is to help you balance reasonable risk in order to obtain reasonable returns. This is going to be unique to every individual and family.
Some final thoughts.
Before you do anything else, get an idea of your risk tolerance to help you better understand yourself. Doing so should help you sleep better at night, as well as be able to enjoy life today. Hopefully even when the market is doing crazy things.
The content you just read is for informational purposes only. Yes, I’m a financial advisor, but this article really isn’t intended as advice for you specifically. Your unique situation needs to be taken into account, and the ideas presented here may not apply.
So, please make sure you do your due diligence BEFORE implementing anything. Due diligence may include hiring a qualified professional who understands your situation completely and can offer you personalized advice.