Why Consider Risk-Tolerance?

The third quarter is almost complete and many major asset classes have posted negative returns for quarter, year-to-date, and trailing 12 months. The current environment is a good one to illustrate why investors should consider their risk-tolerance.

With many markets down 5-15% YTD, imagine a hypothetical investor that could only stomach a 5% decline in the market value of his/her portfolio. Regardless of the underlying value of the portfolio or future return prospects, that investor would fixate upon price and mark-to-market losses. Rationality departs and, in my experience, that investor would:
#1: be an anxious and nervous wreck
#2: give serious thought to liquidating the portfolio

If an investor is exposed to more price volatility than he/she can emotionally handle and sells at a bad time, it would’ve been better to invest in a low-risk low-return portfolio from the start. While I do not think volatility is necessarily risk, it can be risk if it causes poor behavior. That is why all investors must at least consider risk- tolerance, regardless of investment philosophy or approach.