Tuesday, October 9, 2012

Risk Tolerance

So, an investor might have the primary objective of growth/capital appreciation. He may also have a time horizon of 20 years. However, if he doesn’t have the risk tolerance required of the stock market, we have to keep him out of stocks. Remember that risk tolerance has to do with not only the financial resources, but also the psychological ability to sustain wide fluctuations in market value, as well as the occasional loss of principal that makes investing so much fun in the first place. The terms “risk-averse,” “conservative,” and “low risk tolerance” all mean the same thing—these investors will not tolerate big market drops. They invest in safe, boring things like fixed annuities, US Treasuries, and investment-grade bonds. In order to invest in sector funds or emerging market funds the investor needs a high risk tolerance. Moderate risk tolerance would likely match up with balanced funds, equity income funds, and conservative bond funds.
Putting the three together (investment objectives, time horizon, risk tolerance), then, if we know the investor in the question seeks growth, we then have to know his time horizon and risk tolerance. If he’s a 32-year-old in an IRA account, his time horizon is long-term. Unless he has a low risk tolerance you would almost have to recommend growth funds. If the investor is 60 years old and living on a pension income, she might need to invest in common stock to protect her purchasing power. If so, her time horizon is long, but maybe her risk tolerance is lower than the 32-year-old's. So, we’d probably find a conservative stock fund—not a small cap growth or “international discovery” fund—maybe a growth & income or equity income fund. If another investor seeks income primarily, we need to know her time horizon and risk tolerance. We don’t buy bonds that mature beyond her anticipated holding period. If she has a 10-year time horizon, we need bonds that mature in 10 years or sooner. Her risk tolerance will tell us if we can maximize her income with high-yield bonds, or if we should instead be smart and buy investment-grade bond funds. If she needs tax-exempt income, clearly, we put some of her money into municipal bond funds. For capital preservation nothing beats US Treasury securities. GNMA securities are also very safe. Money market mutual funds are safe—though not guaranteed by the US Government or anyone else—but they pay low yields. Money market mutual funds are for people who not only want to preserve capital but also make frequent withdrawals from the account. See, even though your money is safer in a 30-year Treasury bond than in a money market mutual fund, the big difference is that the market price of your T-bond fluctuates (rates up, price down), while the money market mutual fund stays at  $1 per share.
Seriously. So if liquidity is a major concern, the money market mutual fund is actually better than T-bonds, T-notes, and even T-bills, all of which have to be sold at whatever price. With the money market mutual fund, you can write checks, and the fund company will redeem the right number of shares to cover it.
Total liquidity. And totally boring, just as many investors like it.Suitability Questions for Series 7

No comments:

Post a Comment