The Need-First Approach – 4 questions to ask yourself
To determine your risk tolerance, start by assessing your needs. Ask questions like:
1. What is your investment time horizon?
The length of time you plan to keep your money invested impacts your ability to take on risk. Longer time horizons allow for greater exposure to high-growth assets like equities, as they provide more time to recover from market fluctuations.
The graph below shows the growth of the JSE All Share Index vs Money Market performance over the last 25 years.
Over time, the equity market will outperform more conservative assets such as money market, however, volatility may lead to short-term losses. Shorter time horizons require a more conservative approach to preserve capital.
2. Will you be drawing an income?
If you need regular withdrawals from your investment, it’s important to balance risk and stability. Higher-risk investments can result in short-term losses, which could impact your ability to sustain a certain level of withdrawals, as you may be forced to withdraw during periods of negative returns. This is known as sequencing risk.
Coronation gave this example of sequencing risk.
A portfolio may perform at an average of 11% over 3 years, by achieving the following returns:
Year 1: 14%
Year 2: 29%
Year 3: -7%
However, two investors, with the same initial capital, and the same regular withdrawals, but with differing order of returns, will have differing results.
Despite having the same strategy, the impact of withdrawals can have an impact on your outcome.
A more conservative portfolio with income-generating assets, and therefore lower volatility, may be preferable for those who need to draw regularly.
3. How comfortable are you with market fluctuations?
Some investors are comfortable seeing their portfolio decline temporarily, while others may panic and sell at the wrong time, cementing in a loss.
Your personal risk tolerance should align with your ability to endure market ups and downs without making impulsive decisions. If market dips cause stress or lead to premature selling, a more balanced or conservative approach may be necessary to ensure you stick with your chosen investment strategy.
One way to assess your comfort level is to review past market downturns and consider how you would have reacted. If short-term losses don’t deter you from your long-term goals, you may be suited to a higher-risk portfolio. However, if you find market declines unsettling, a lower-risk approach with a focus on stability may be more appropriate. A diversified portfolio that balances risk with stability can help prevent emotional decision-making during volatile periods.
4. Do you need to take on risk to achieve your goals?
If your financial goals require higher returns, you may need to accept more risk. However, taking on unnecessary risk beyond what is needed for your goals could expose you to volatility without added benefit.
For long-term goals, such as retirement savings, a higher level of risk may be appropriate as the market’s natural fluctuations could result in higher long-term growth. On the other hand, if your goals are short-term—such as purchasing a home or funding education—capital preservation should be a priority, and a lower-risk portfolio should be more suitable.
Understanding the level of risk required to meet your goals ensures that you take on only what is necessary, avoiding unnecessary exposure to volatility. Aligning your risk level with your specific objectives allows you to maintain a strategy that balances growth and stability effectively.
In Conclusion
Understanding your risk profile is essential for building a portfolio that aligns with your financial goals and comfort level. By assessing your investment time horizon, income needs, and risk tolerance, you can create a strategy that balances growth with stability. A well-structured portfolio ensures that you stay on track to meet your objectives while managing market volatility effectively.
