10.4.2 Risk Tolerance
Risk tolerance is the ability of an investor to tolerate a decline in her portfolio’s value. Investors with lower risk tolerance are sometimes said to be more conservative. Those with higher risk tolerance are sometimes said to be more aggressive.
Though many different factors should be considered when determining suitability and proper asset allocation for a customer, there are some basics to follow when defining investors and investments. First of all, asset allocation is driven primarily by what you need the money for, and how soon. Do you need it to buy groceries tomorrow? Do you need it for a down-payment on a house in the next five years? Or do you want to save it for retirement or for a trust for your future grandchildren? If you need the money for groceries tomorrow, you can’t afford any swings in the value of your portfolio and you should have your money in cash. But if you’re saving to buy a house in 5 years or saving 30 years for retirement, there is more time for your portfolio to recover from setbacks.
Conservative investors often fall into three types: (1) individuals who are approaching or are at retirement age; (2) individuals who have limited financial resources, including a low or negative net worth; or 3) individuals who will need their invested funds in the near-term. A conservative investor needs to minimize the risk of losing money and have the opportunity to earn income from his investments. Asset allocation for conservative investors might be 20% to 40% equities, mostly blue-chip and dividend-paying stocks, as well as mutual funds or ETFs. The rest of a conservative investor’s portfolio might be in fixed-income securities, such as corporate bonds, bond funds, Treasury securities, and for higher-income investors (particularly in high-tax states), municipal bonds. A risk for a conservative investor is that the income from his investments is not sufficient. In order to protect a conservative investor