Age and Risk Tolerance

Understanding Risk Tolerances

Risk tolerance is the degree of uncertainty in investment returns that an investor is willing to endure. It is crucial to understand your own risk tolerance when choosing an asset allocation. Various questionnaires and professional consultations can assist in determining how much risk you are comfortable taking.

Investors need to honestly answer the question of how important the short-term fluctuation risks are relative to the risk of missing long-term return targets. Most important, however, is not to overestimate one's own capacity to suffer. In times of crisis, investors' nerves get the better of them faster than some might think.

Age-based Asset Allocation Models

Asset allocation strategies often consider the investor's age as a key factor. Younger investors generally have a longer time horizon and can afford to take on more risk for potentially higher returns.

As one ages, the asset allocation may shift to more conservative investments to preserve capital.

Asset Allocation for Different Life Stages

Just as age affects asset allocation, so do different life stages. For instance, the asset allocation of a young professional may differ greatly from that of a retiree. During the accumulation stage, riskier assets like equities may be more prevalent. As one transitions to the distribution phase in retirement, short term bonds and other less volatile investments often become more prominent.

The most important resource for investors is time. The older investors get, the scarcer this resource becomes, making the avoidance of steep drawdowns more relevant than it is when someone is just starting to invest at a young age.

Behavioral Aspects of Risk Tolerance

Often, investors overestimate their actual risk tolerance due to behavioral biases. For example, during bull markets, an investor might be more willing to take on risk, mistaking market conditions as a personal ability to endure risk.

Understanding these behavioral aspects can help in making more rational asset allocation decisions. One bad emotional decision at the wrong time can undo years of success.

How Life Events Impact Asset Allocation

Major life events such as marriage, having children, or receiving an inheritance can significantly influence your asset allocation strategy. These events might necessitate more immediate liquidity, or allow for increased long-term investments, requiring a reevaluation of your asset allocation.