Your Investments: Risk tolerance and investment objectives

A pensioner who is living from the income generated from his portfolio can’t afford to take those same risks because he needs to know that he will be able to generate enough money to cover his expenses.

By AARON KATSMAN
Dollar bills 370 (photo credit: Steve Marcus / Reuters)
Dollar bills 370
(photo credit: Steve Marcus / Reuters)
When you read a personal-finance article, have you ever wondered what the terms “investment objective” and “risk tolerance” actually mean? When I ask potential investors what their investment objective is, they invariably answer, “To make money. Isn’t that everyone’s goal?” However, although there is some truth to that response, there are also other factors involved. All investors have specific goals or objectives, such as seeking more income, long-term growth, trading or speculating. In addition, all investors also have a risk tolerance, meaning the level of risk of actually losing money that they are prepared to tolerate to realize their investment goals.
Although all investments possess an element of risk, including the potential loss of principal, securities such as stocks 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.
Important terms
Investment objectives span a wide spectrum. Generally, investors seeking to generate income usually have the least amount of higher-risk investments in their accounts, while those who are involved in trading and speculation 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/speculation 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. Such investors are willing to accept a lower level of income in exchange for lesser risk. Equities will typically not be a large percentage of the account.
For example, an investor 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-ter m time horizon, and he seeks the higher longterm return potential associated with these higher-risk investments.
Conversely, a pensioner who is living from the income generated from his portfolio can’t afford to take those same risks because he needs to know that he will be able to generate enough money to cover his expenses.
Keep it current
One ongoing and common problem among investors is that they may not take the time to actually update their portfolios. It is important to note that what may be an appropriate investment at the age of 35 may have outlived its usefulness by the time the investor reaches the age of 60. This situation is especially the case for people who have immigrated to Israel, leaving investment accounts behind in the United States. Such investors may think that their portfolio is extremely suitable in their current situation, but it soon emerges that they are much more aggressive than they should be.
Take stock
It is vitally important for individual investors to take stock of their current investments, as well as their specific investment objectives. To begin, it is worthwhile defining your actual financial goals. Include short-term objectives, such as paying for a child’s kaitana (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, the investor should look at his portfolio and see if he is either being too aggressive or maybe even too conservative to achieve these objectives.
If you feel that 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 particular 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 goals that can be achieved.
The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc., or its affiliates.
aaron@lighthousecapital.co.il
Aaron Katsman is a licensed financial professional in Israel and the United States who helps people with US investment accounts. He is the author of the book Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing.