Risk Avoidance vs Risk Tolerance

A few days ago, I wrote about determining your risk tolerance.  As I stated there, risk tolerance is the degree of uncertainty you as an investor can handle in regard to a negative change in the value of your portfolio.  That is, how much of a loss would you be willing to endure in the short-term in exchange for higher potential returns in the long term?  Risk tolerance is a very personal thing.  Some people are perfectly comfortable with the wild gyrations of the stock market while others prefer the safety of bonds or CDs.  Finding your risk tolerance is all about striking a balance between your desire for higher returns and your need for safety so you can sleep at night.  Determining your personal risk tolerance is key to being a successful investor, but equally important is the concept of risk avoidance.

Risk Avoidance 

Risk avoidance is the act of consciously avoiding risk even though you have the capacity to handle it.  Let’s say you’ve worked hard all your life.  You educated yourself about investing at an early age, calculated how much you would need to retire, and invested heavily in stocks over the course of your career.  You lived through a few severe bear markets with nary a flinch, continuing to sock money away month after month.  In short, you were a model investor.

As a reward for all your hard work and careful planning, you one day discover you’ve reached your retirement goal a full 10 years before you plan to retire.  What do you do?  Well, you could act like nothing has changed and continue invest the majority of your portfolio in stock funds, but is that really necessary?  At this point, you are probably more interested in preserving what you’ve got than earning huge returns in the future.  Since you’ve already reached your goal, your ABILITY to take risk is as high as ever.  You’ve still got 10 years left until you retire, which in all likelihood is enough time to smooth out the short-term fluctuations of the market and don’t forget, you’ll still be maxing out your retirement account all that time.  Many might be tempted to stay the course in this situation, and there’s nothing wrong with that.  But what if something goes wrong?

Avoiding The Worst-Case Scenario

A wise man once said

“No reward will ever be large enough if the consequences of losing are too much to bare.”

Sure, it’s quite likely you’d come out ahead by continuing the aggressive investment policy that’s served you well so far, but for me, the danger of losing what’s I’ve accumulated, no matter how small, far outweighs the potential reward of an even fatter nest egg.  If this were me, I would probably rethink my asset allocation and invest perhaps 60% of my portfolio in bonds and only 40% in stocks.  Sure, I’ll probably only earn 2 or 3% over inflation if I do that, but so what?  The peace of mind that comes with knowing you’re set for life would far outweigh the knowledge that I’m leaving money on the table. 

In this case, my need to take risk differs significantly from my ability to take risk.  Since I wasn’t fazed by previous bear markets, I clearly have a high tolerane for risk.  But risk tolerance is simply defined as the maximum amount of risk you can psychologically bear.  There’s no rule saying you have to always invest at your maximum risk tolerance, though.  When need and ability differ, need should win out.  After all, a bird in the hand is worth two in the bush.