THE BLOG

Warning: Is Your Risk Tolerance Increasing?

04/08/2014 08:37 pm ET | Updated Jun 08, 2014

Lately I have been having more and more conversations about changing portfolios!

"Change them how?" you ask. By increasing the risk of the portfolio.

In the 20-plus years that I've been advising clients, I've seen it during every bull market. Investors' risk tolerance gets higher. They just get comfortable with it, like it will last forever.

On the flip side, in bear markets, everyone's risk tolerance goes down. I've said time and time again that you need to pick an overall risk tolerance for both good and bad markets and stick with it. Don't change it with every movement of the markets.

Sometimes investors will confuse recent successes and tend to be more aggressive. It can give you a false sense of investment prowess. Then things turn south, and you pay for it.

So how does a poor investor figure out their risk tolerance? With the help of an advisor, of course. Start working with a qualified financial advisor on this very important component of investing. Here are some questions that an advisor might ask you about your risk tolerance:

1. What is your time frame? This is probably the most important question on the list. Risk is relevant to time frame. If you have decades to invest, then it's highly likely that you can weather the volatility of the markets and be more aggressive. However, if your time frame is short, you have less time to make up declines that will eventually take place.

2. Would you choose this risk tolerance if the markets were down several thousand points? I think this question is a real test of whether you would approach your risk tolerance the same way in a declining market. If so, go for it. If not, then think twice about being more aggressive.

3. How do you react to volatility? When you read the news that the market soars or dive bombs, how do you react? Do you get upset, check your accounts and pace the floors? Or do you blow it off and accept the fact that volatility is all a part of it? Think about this. What do you do with existing investments? Do you change them and move out of stocks, or do you leave them alone or even invest more? Your answers will determine what your risk tolerance really is.

Determining risk tolerance is a true art. It's subjective and different for everyone. It's where a good financial advisor can earn his keep.

Many financial advisors use a tool called a risk tolerance questionnaire. It has questions that try to determine your level of risk. I've seen quite a few risk tolerance questionnaires over the years. Some are terrible, and some are very accurate. Use a questionnaire, but back it up with a good advisor and the answers to the questions above. Risk tolerance really is that important. It will determine your long-term happiness during bull and bear markets.

Content concerning financial matters, trading or investments is for informational purposes only and should not be relied upon in making financial, trading or investment decisions.

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