The notion that more risk equals more reward is a truism of investing and modern portfolio management. So why wouldn’t a rational investor seek out the greatest amount of risk when selecting investments for her portfolio? And how might we go about setting a portfolio “risk budget” that is appropriate for achieving our specific financial goals while simultaneously aligning with our personal risk preferences and tolerances?
There are both quantitative and behavioral reasons for dialing down our allocation to risk. The “smoothing” effect of time on investment returns implies that longer-term goals can be—in fact, need to be—funded by higher risk investments. The priority of our goals one to another also influences our risk appetite, in that higher priority goals require higher levels of statistical confidence that can only be achieved with lower risk investments. In addition, there are the many future unknowns—of both the known and unknown varieties—the potential impact of which are either mitigated or exacerbated by our chosen level of risk. Finally, our own behavioral tendencies influence both the types of risk and the overall level of risk which we can tolerate without succumbing to wealth-destroying behaviors.
Above all, goals-based investors remain ever conscious of the rate of return required to achieve their goals and bear in mind that hurdle rate when reviewing potential investments.
- Speaker: Jack Parham – Chief Investment Advisor, Eton Advisors Group
- Host: Greg Dixon – Marketing Consultant, Eton Advisors Group