A guide to understanding investment risk tolerance for small business owners
Constructing an investment portfolio to help small business owners secure their retirement has many factors, but the most important one is to help my clients understand their personal risk tolerance when investing their hard-earned money. It is this risk tolerance that helps me set the most appropriate investment strategy for each of my clients.
Investment risk tolerance can be defined as the level of risk an individual is willing to take within their investment portfolio. Factors that can influence the investment risk tolerance of a small business owner include their time horizon for a specific goal, current financial circumstance, and emotion. I will provide more details about these factors below.
Factors that influence investment risk tolerance
Time horizon for a specific goal
This is the number of years an individual plans to maintain an investment before they need to access the money in their account. With a longer time horizon, an individual is generally willing to take on more risk as there will be more time to recover from market downturns. Different financial goals will have different time horizons, which can result in multiple risk tolerances for the same individual. For example, a small business owner who is investing in a 529 college savings plan for their child’s college education and in a SEP-IRA for their own retirement will have two completely different time horizons for these goals. Their child might be attending college in 10-15 years, whereas their own retirement could be 25-30 years from now.
Current financial circumstance
A small business owner with strong financial health (e.g., stable stream of income, adequate emergency cash savings in place, minimal debt) is generally willing to take on more risk with their investments because they know they have stability within their overall financial profile.
Emotion
This factor cannot be calculated, but still has much influence on the investment risk tolerance of a small business owner because the nature of some individuals is to be more risk-averse, whereas some other individuals enjoy being risk takers. Knowing an individual’s emotional reaction to a market downturn will provide much insight into their investment risk tolerance.
How to assess investment risk tolerance
Assessing investment risk tolerance is not an exact science as there are different methods available that can be both quantitative and qualitative. One of the more common ways for a small business owner to assess their investment risk tolerance is to complete a self-assessment questionnaire, which asks questions related to the factors (time horizon for a specific goal, current financial circumstance, emotion) that I noted above. Even though it is difficult to know the exact year that an investment will be needed, it is still important for a small business owner to evaluate the time horizon as best as possible. Based on the responses, the questionnaire will provide a score that corresponds to the level of risk an individual is willing to take. Even if an individual does not complete an investment risk tolerance questionnaire, another approach would be to simply think about any experience they have had with investing. For example, an individual would think about how they reacted (worried or not worried?) to the most recent stock market downturn, which will provide more clarity about how much risk they are willing to take with their investments.
Categories of investment risk tolerance
There are many categories that can be associated with investment risk tolerance, but there are three broad categories.
Conservative: Lower risk investments such as bonds and savings accounts that have lower investment returns.
Moderate: Balance between lower and higher risk investments with portfolios that generally include some type of mix between stocks and bonds.
Aggressive: Higher risk investments such as stocks and real estate that have potential for higher investment returns.
How Lasting Wealth Principles aligns client portfolios with investment risk tolerance
After going through a full review with my clients and getting a better understanding of their investment risk tolerance, I customize their investment portfolio appropriately. Most importantly, I make sure each client has the most appropriate asset allocation strategy given their investment risk tolerance. For example, one client might have a high tolerance for risk because they project to retire in 25-30 years resulting in a portfolio of 80%-90% stocks and 10-20% bonds, whereas another client with a lesser tolerance for risk could be in a portfolio of 50-60% stocks and 40-50% bonds. Like other things in life, investment risk tolerance is subject to change over time due to life events (e.g., marriage, birth of child) and/or changing financial circumstances. This means that investment risk tolerance should be regularly monitored, which is what I do for my clients within their investment management process. Helping small business owners secure their retirement is one of the cornerstones of Lasting Wealth Principles so understanding investment risk tolerance is particularly important for both the client and me.