Wall Street Steward Blog

What Is Your Risk Tolerance? My 1 to 5 Scale


Hi everyone.  My name is Matt.  Welcome back to wallstreetsteward.com.

Today, we’re going to talk about the most important aspect of investing, if you ask me.  What is your risk tolerance?  What is your number?  I use a 1 to 5 scale.  I’ll be the first to say my way is not perfect.  It’s not the only way.  I’m trying not to pick my nose here.  It’s not perfect, alright?  But, it’s worked for me for the last ten to twelve-fifteen years.  And, it’s very simple.  It’s very easy to articulate.  I have seen it as a good judge of actually judging what someone’s true risk is.

Now, let me show you how it works.  Mr. Jones, on a 1 to 5 scale, with 1 being very conservative, very scared, want your money to be safe, scared of your own shadow and 5 being very aggressive, a lot of up and down, investments such as stocks.  Where do you fall on this scale?  1, 2, 3, 4, 5, big picture. 

Now, let me show you how this goes.  Mr. Jones, where do you fall on this scale?  “Well, I think I’d be about a 4.”  Ok.  First of all, I operate on the premise that people don’t really know where they fall on this scale and they’re trying to be honest, but most times they don’t peg their number exactly, because this is what happens.  Ok, Mr. Jones so you’re saying on that 1 to 5 scale, you’d like to be a 4.  Now, as a 4 you can expect a rate of return over a long period of time of somewhere in the 8% range.  Now, so my compliance folks are happy, over a long period 8% average per year doesn’t mean it’s going to go up 8 every year.  It also doesn’t mean it’s going to go up 6, and then 10, and then 9, and then 7.  It can be up 25, down 10, up 2, up 8, things like that can average 8%. 

Now, Mr. Jones I know that sounds good to you.  However, if we’re wrong, if you invest like a 4 and we have an awful year, such as 2008, you can expect lose somewhere in this range, 30% a year.  Is that ok with you?  “Ugh, ah, yeah I guess that’d be ok as long as it comes back, right?”  Mr. Jones it may or may not come back and it might take a long period of time.  Let me put it to you a different way.  If you invest $100,000 and it goes to $70,000 would that keep you awake at night?  Not would you like it?  No one likes to lose money.  Would you lose sleep if we lost you $30,000?  “Man, yeah!  I don’t want to lose $30,000!”  Mr. Jones in my opinion you are not a 4. 

Now, let’s look at what a 3 would be.  If we invest somewhere around a 3, we’re going to earn approximately 6% a year on average and that catastrophic year would be more like 20% or $20,000 on a $100,000 investment.   Are you ok with that?  “Yeah, I reckon I could live with that.”  Ok.  That being said, if you give me $100,000 to invest and I lose you $20,000, you’re going to be okay with that?  Really?  So, if I lose you a Honda Accord, you’re going to be able to live with that?  “Well, I don’t know, that’d be ok.”  Mr. Jones is about a 3.  Ok.  That’s the only accurate way I’ve been able to determine someone’s risk over the years.  And, it’s not so much in what they say as it is how they say it.

For example, when you go to the doctor the first time and they ask you what medications are you taking?  They’re not asking because they’re going to call the police on you folks.  If you walk into the doctor and go you know I have this really horrible heroin addiction.  They’re not going to say great, wait right here, I’m going to go call the police department and have them come in here and arrest you.  They’re not asking you for that reason.  They’re asking you because they’re trying not to kill you.  Ok?  Same situation here.  Tell the truth.  Don’t fudge the numbers to try to act bad or cool or like you want to take more risk than you’re comfortable taking.  Also, non-verbal clues are big.  Many advisors are listening to this.  I watch a lot of non-verbal communication.  If someone covers their face, if they cover their midsection up like this, if you see them pause a little bit, they look at each other if its husband and wife, whose numbers by the way can be different on this, so ask both.  Non-verbal clues are a big deal.  I’ll show you that here in a second.

Let’s assume I ask the same questions to Mrs. Jones this time.  Mrs. Jones on a scale from 1 to 5 with 1 being very conservative, very safe, with 5 being very aggressive, a lot of up and down, where do you think you’re comfortable?  “Oh, I’d say probably about a 3.”  So, you’re a 3.  Same drill.  I’ll cut to the chase on the video, because you don’t care about the rest of it.  So, again, you might average 6% over time, during that whole year we’re going to lose about 20%.  Alright?  Are you ok with that Mrs. Smith?  “Yeeeahhhh?”  Ok, her voice cracked.  Alright.  Mrs. Jones are sure you’re going to be ok with your $10,000 investment going down to $8,000.  “Well no, I don’t want to lose that much money!”  Mrs. Jones is not a 3.  This is the only way to qualify risk in my opinion.  In my opinion, it’s the only way it’s ever worked for me. 

Now, a couple things about this scale.  Number one, people’s risk tolerance changes.  If the market’s doing very well it’s quite possible they’re over here at a 5 or here at a 4.  They’re feeling very confident.  In less certain times, they’re going to be over here at a 2.  They’re more nervous.  So, I consistently ask people this question.  On a 1 to 5 scale, if they’ve been a client a long time, they’ll roll their eyes, “yes Matt I’m still a 4, leave me alone” ok.  I also ask it about different pools of money.  For example, they have this pool of money over here for retirement that’s more longer term in nature, and they have this pool of money that is their checking and savings accounts.  This is their safe money, if you will.  They’re probably not going to be on the same risk parameters with this money as they are here.  More than likely down here, they’re going to be more like a 1, maybe a 2 with this money.  Over here they’re probably going to be a little more aggressive if they have a longer term time horizon. 

So, that being said, this number is not age specific.  Not age specific.  There are some very famous television personalities, people that get paid to stand up and talk, who love to say Mr. Jones you’re 75 years old, that means you ought to have 75% of your money in bonds.  Bologna, it does not mean that.  Ok?  I have a neighbor who’s about 75 years old, who’s an ex Wall Street trader, he’s a 4 or a 5 on this scale.  He understands how it works.  He has plenty of money.  He has the risk tolerance and the stomach to live with it.  Ok?  If I told him to put 90% of his money in bonds, he would laugh at me.  Alright?  I also have a couple of clients who are 18 years old, very young, long term time horizon.  They are scared of their own shadow.  They are horrified.  They asked the question if I invest $100 could it go down to $99?  Ok?  That’s the type of thing we’re talking about.  So, this is not age specific.  Not at all in my opinion.

That being said, the only way to truly judge how much risk you can stomach is if I or someone like myself, perhaps not quite as dressed up, lost you money, where is that point would you physically lose sleep at night, where it physically bothers you.  Not it makes you mad, because everybody’s mad when they lose money folks.  But where does it start to physically and emotionally scare you?

That being said, if an advisor doesn’t spend a lot of time getting to know where your risk tolerance is on a scale similar to this one, then they’re doing you a disservice in my opinion.  If they ask you’re the question are you conservative, moderate or aggressive, that’s not enough folks, because most people are going to say moderate.  That doesn’t quantify anything.  That doesn’t give you an expected rate of return or anything like that. 

That being said, if you ever call me or ask me my opinion about what should I do with blank.  “I have this money sitting over here.  What do you think I should invest in?”  My question is going to be Mrs. Jones, Mr. Smith, Stewart, Samuel, Rhonda, whatever your name is, on a scale from 1 to 5 with 1 being very conservative, things like CD’s, money markets, scared of your shadow, and 5 being very aggressive, things like stocks that can go up and down and all over the place.  Where do you think you’d be comfortable on this scale?  And then, we have to shut up and we have to listen and we have to stop talking and we have to watch for non-verbal communication.

Thank you for listening.  If you have any questions, concerns, feedback, comments, or general information you want to send my way, I’d appreciate it.  Have a great day.  Take care.