The #1 Factor You Control That Impacts Your Returns Most
Summer is right around the corner and that means BBQ’s, weekends at the cabin and most importantly, reconnecting with friends and family. Inevitably, people will discuss the markets and how their investment portfolios are doing. With all the headlines and market volatility, it has been another wild start to the year and makes for good conversation. When this conversation reveals that your cousin Eddie is up 20% while your portfolio is up 5%, how will you feel? What will be the most important question you ask to understand the difference? What stock does he own? Who is guiding his investments decisions? Are you doing poorly? None of these questions will provide the answer you are looking for, but there is one that will:
How much risk are you willing and able to take?
I understand that question isn’t going to get you any enthusiasm at the next gathering, but it is that dry question that will provide the most meaningful answer. If Eddie is willing to bet the farm and able to do so, it’s very possible he will post some outstanding returns. Alternatively, if you are not willing to risk the farm and/or are not able to do so, your returns will look very different. Willingness and ability combine to form what is known as your risk tolerance or tolerance to take on risk. It’s important to understand what your risk tolerance is and how it influences your outcomes. This article will cover just that.
What is Willingness?
What “willingness” means for investors is your psychological comfort with risk, how you feel when markets swing wildly and how willing you are to take on risk.
Do you stay calm during a 20% market drop, or does it keep you up at night?
Are you tempted to sell everything when headlines scream “crisis,” or do you see volatility as the necessary price of long-term growth?
A recent conversation I had addressed the willingness to take risk perfectly. They stated “I can’t risk living under a bridge anymore in pursuit of driving a Lamborghini I don’t’ need.” Clearly, they were not willing to take high levels of risk with their investment portfolio. This does not mean they are not willing to take risk at all but they do have a higher preference for safety and security over risk. Everyone will find their place somewhere on the continuum between zero risk and high risk.
How do High and Low Willingness Differ?
High-willingness investors can emotionally handle aggressive strategies like stocks, growth funds, or concentrated positions. Low-willingness investors prefer stability, even if it means accepting lower expected returns. Where someone stands can change over time. This is especially true when you approach different life or market stages. Approaching the time when you will live off income from your assets can lower your willingness to take risk. A bear market can also cause people to lower their willingness to take on risk. This is why it’s important to maintain an ongoing discussion about risk so that you are positioned in-line with the risk you are willing to assume.
Here are some key considerations regarding your willingness to take on risk.
Personality Traits and Risk Attitude
Traits including optimism, openness, anxiety levels, or general risk aversion determine whether you naturally lean toward excitement from potential gains or discomfort from uncertainty. Some people are inherently risk-seeking while others are highly risk-averse.
Comfort Level with Losses
How do you feel about seeing your portfolio drop 20-30% in a market pullback? This includes loss aversion and your ability to tolerate short-term pain for long-term reward. The classic test is whether you'd lose sleep or sell in a panic versus staying the course.
Past Investment Experience
Successes or traumas such as losing money in a previous crash or growing up in a household that viewed investing as gambling heavily color your current comfort level. Positive experiences often increase willingness; painful ones can decrease it long-term.
Financial Literacy
Greater understanding of how financial markets work and historical cycles in volatility tends to increase willingness. Those with less understanding of investing often feel anxious because uncertainty feels scarier without context.
Behavioral and Psychological Propensities
Factors including trust in markets, what your peers are doing, mood, and economic expectations.
What is Ability?
Ability is the risk capacity that your financial situation allows and is an objective measure. Looking at your assets, liabilities, income and expenses establishes a mathematical projection for how much risk your situation can withstand. Think of a car with a full tank of gas. That tank of gas does not mean you have to drive it on a 100 mile road trip but it does have the ability. This contrasts with willingness because you might be willing to drive 100 miles but if the empty signal is flashing, you don’t have the ability. Therefore, without the ability there is no level of willingness that can fully offset that without a bad outcome. In the car example, running out of gas in the desert will not end well and is a bad outcome. So, the key question to ask is:
“What is your financial ability to absorb losses without derailing your life plan?”
Here are the primary factors to determine ability:
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Time Horizon
How many years until you need the money? A longer runway of 20+ years dramatically increases capacity because markets have time to recover. A retiree already drawing income has far lower capacity.
Human Capital or Ability to Generate Higher Future Income
Reliable salaries, pensions, or multiple income streams raise capacity. We also evaluate your human capital. Human Capital is the industry term for your future earning potential. This acts like an asset that can offset investment risk.
Net Worth and Liquid Assets
A strong balance sheet, substantial emergency fund covering 6 to 12 months of expenses, and accessible savings increase capacity. Liquidity includes assets than can be sold without triggering unnecessary taxes or penalties.
Spending Needs
High fixed costs like mortgage, healthcare, education, and dependents lower capacity because they leave less room for market losses.
Liabilities and Debt
Significant debt, especially variable-rate or short-term, reduces capacity by creating obligations that must be met regardless of market performance.
Liquidity Requirements
The more cash you’ll need in the next 1–3 years, the lower your capacity for investments the fluctuate in price.
What is your Risk Tolerance?
Once you understand your willingness and ability to take risk you can make a reasonable determination known as your risk tolerance or tolerance to take on risk. Below is a general quadrant system for the different combinations of willingness and ability. A high willingness combined with high ability will support a high-risk tolerance. A low willingness and low ability combination will support a low risk tolerance.
Another, more exact approach representation may be to use the scale below.
This is a scale we use internally to visualize someone’s risk tolerance and ranges from Very Conservative to Very Aggressive. The gray bubble with 55 in it represents how someone’s risk tolerance might appear on the scale. Each risk step along the way is determined by combining the answers you provide from our risk tolerance questionnaire combined with our individual assessment and conversations with you. Our professional opinion is more subjective and incorporates our professional judgment. It’s important to understand that the questionnaire is only part of the puzzle and should not be viewed as a test to determine your fate. We are only using it as one input in the overall assessment. Furthermore, there is nothing stopping you from controlling how your money is invested in terms of risk. If you want risk, you will get risk, and if you want safety, you will get safety. You are the captain of your own destiny, and we are here to work with you steering the ship.
Now that you have a better understanding why your cousin Eddie might be up 20% while you’re only up 5%, you will be ready to focus on what matters most. Is your portfolio allocation right for you and your goals?
What can you do to ensure you’re positioned correctly? Communicating with your advisor is the most important step to take after reading this. Ensuring your portfolio has the appropriate amount of risk will help you stay the course and enjoy the benefits of compounding over time. Completing the occasional risk tolerance questionnaire is very helpful along with updating your financials and communicating. If we can properly assess your willingness and ability to take risk, it will help you achieve your goals and give us the best chance of achieving the best returns for you.
Hopefully, this article will benefit you, a friend or family member.
Thank you for taking the time to read this planning commentary. I pray it helps you or someone you care about.
Kyle Lottman, CFA, CMT, CPA
Wealth Management Advisor
Elevate Capital Advisors
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This commentary expresses the views of the author as of the date indicated and such views are subject to change without notice. Elevate Capital Advisors, LLC (“Elevate”) has no duty or obligation to update the information contained herein. This information is being made available for educational purposes only. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Elevate believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Elevate. Further, wherever there exists the potential for profit there is also the risk of loss.
