Your investments: Risk tolerance and investment objectives

By AARON KATSMAN
July 22, 2010 05:25

Making money without risk like my seven-year-old's approach to betting.

3 minute read.



Aaron Katsman

Aaron Katsman 58. (photo credit: Courtesy)

Personal-finance articles often throw around the terms “investment objective” and “risk tolerance.” What do these terms mean? When I ask potential investors what their investment objective is, they invariably answer: “To make money with no risk. Isn’t that everyone’s goal?” While this kind of answer seems to make sense, it sounds like my seven-year-old son’s approach to betting. Now don’t think I’m a bad father and that I encourage my boy to gamble; it’s just that he is at the age that whenever there is an issue and he thinks he is correct, he automatically says: “I’ll bet you a thousand shekels that I’m right.”

One of the issues with my son’s approach is that he doesn’t yet grasp that if he is wrong there is a consequence: he has to cough up the cash. While making a lot of money and taking absolutely zero risk sounds like a dream come true, it is, unfortunately, just a dream and not based in reality.

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Although all investments possess an element of risk, including the potential loss of principal, securities such as stocks, among others, are more risky than other types of investments. At the same time, although higher-risk investments may have the potential for higher returns, they can also lead to greater losses. Therefore, the higher an investor’s risk tolerance is, the more he will invest in higher-risk securities offering the potential for greater returns.

FINANCIAL GLOSSARY
Investment objectives span a wide spectrum.

Investors seeking to generate income to live off of have much less exposure to risk in their portfolio, while those who are involved in trading and speculation generally take the most risks. Similarly, risk tolerances follow a spectrum starting with “conservative,” moving on to “moderate,” and finally “trading/speculating.”

Each stage involves a higher level of risk.

The definition of trading/speculating is suitable for investors seeking out maximum return through a broad range of investment strategies generally involving a high level of risk, including a potential, significant loss of principal.

On the other hand, a conservative income investor would be defined as an investor seeking the maximum amount of income consistent with a modest degree of risk.

For example, a client with a long-term risk tolerance can deal with short-term market volatility that comes with a portfolio of higher-risk investments. This is because the investor has a long-term time horizon, and he seeks the higher long-term return potential associated with these higher- risk investments.

Conversely, a pensioner who is living off the income generated from his portfolio can’t afford to take those same risks because he needs to know he will be able to generate enough money to cover his expenses and not lose any principal.

KEEP IT CURRENT
A common problem among investors is that their portfolio hasn’t been updated in years. An appropriate investment at the age of 35 may have outlived its usefulness by the time the investor reaches 60. This situation is especially the case for people who have immigrated to Israel, leaving investment accounts behind in the United States. While their portfolio was suitable to their situation back in Woodmere, Long Island, 12 years ago, it may be completely inappropriate as a retiree in Rehavia.

TAKE STOCK
It is vitally important for individual investors to take stock of their current investments and their investment objectives.


To begin with, define your financial goals. Include short-term objectives, such as paying for a child’s day camp, as well as more long-term objectives, such as marrying off your children and paying for your own retirement. Once these goals have been defined, you should look at your portfolio and see if you are being too aggressive or maybe even too conservative to achieve these objectives.

If you feel you are not capable of such analysis, it may be worthwhile seeking the help of a professional adviser. A licensed professional adviser will help you take an objective look at your current holdings and give recommendations for making your portfolio more efficient and compatible with your situation. Use your adviser as a sounding board. He can tell you if your goals are realistic; if not, you can work together to come up with attainable goals.

aaron@lighthousecapital.co.il

Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people open investment accounts in the US.


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