What does the future hold for investors? The bulls or the bears have wildly varying opinions. We don't fully subscribe to one or the other but listen to both and do our best to make sure our clients get real returns in both the good times and bad times. Before we can assist clients with asset allocations, we need to make sure they and we understand their risk tolerance.

Why should you re-evaluate your risk tolerance now?

1. To prevent behavioral mistakes. One large behavioral mistake can be disastrous to your financial plan. 
2. Your goals may have changed
3. Your perception of the markets may have changed

What is risk tolerance? The textbook definition is the extent to which an individual would normally choose to risk experiencing a less favorable outcome in the pursuit of a more favorable outcome. Another way to think about it is that your goals drive the investment strategy and your risk tolerance puts limits on it.

There are three aspects of a client's risk profile: Risk tolerance, risk capacity, and risk perception.

Risk tolerance is really "what do you prefer." There are many factors that contribute to shaping your risk tolerance such as gender, income, marital status, do you have dependents, education, etc. There are also psychological, social, and sometimes ethical factors. Risk tolerance is really unique to the individual. Typically we measure this through a comprehensive risk tolerance questionnaire followed up with conversations about the results. Occasionally, we will give a 'gut check' and discuss how a client feels about a hypothetical portfolio performance in historical bear markets.

Risk capacity is "how much risk can you afford to take to reach your goals" or "how much risk do you need to take to reach your goals." We capture your risk capacity through the financial planning process. Simply put, this is an evaluation of your resources, a determination of your goals, and determining what type of investment portfolio is necessary to give you the best chance at success.

Risk perception is "how risky do you think the markets are today." You are constantly bombarded by the media with "the Dow is doing this or that." You may prefer and or need a certain investment allocation, but if you think the markets are in for a crash your risk tolerance may change as your emotions prevail. Conventional financial theory is based on the theory that investors are for the most part rational. There is no doubt that emotions and psychology influence decisions, sometimes overpowering rational judgment. A good example of this is the 'recency bias.' This suggests that we place huge amount of emphasis on the most recent events.

As your capacity and perception change so can your risk tolerance. The behavioral mistakes that come from emotional investing can and will poke holes in your financial plan. The key is understanding the risk you are taking on through education and conversation.

A major objective for us as advisors is to help you assess your risk tolerance, identify the mismatches with your capacity and perception, and assist with the tradeoff decisions. This is an ongoing process. It's not enough to set it one time and forget it. Ongoing annual reviews are essential to make sure that you are taking on the appropriate amount of risk in your portfolio as your life and the markets evolve. Over time, needs will come up, the markets will continue to change, and your goals may change.

When was the last time you evaluated your risk tolerance? When was the last time you thought about your risk capacity? Has it changed? Are there mismatches with your tolerance, capacity, and perception?

Answers to these questions are critical as a starting point before taking on the important responsibility of reviewing your asset allocation. Only then, can your risk tolerance, capacity and perception join with an appropriate mix of stocks, bonds and alternative investments to reduce volatility and anxiety and produce more stable returns and greater peace of mind.