By Meir Statman, Glenn Klimek Professor of Finance at Santa Clara University
Just as there is a difference between being able to afford a luxury car and actually buying a luxury car, there is a difference between being able to afford highrisk investments and choosing a high-risk investment portfolio. Indeed, there is much comfort in knowing that we can afford a luxury car while enjoying a modest one, and there is tranquility in knowing that we can bear high investment risk but only need a portfolio with low or moderate investment risk.
Our willingness to accept risk depends on the distance between our aspirations and our current circumstances. Aspirations are broader than goals and less specific. We aspire to financial security, but we do not necessarily specify “the number” to reach at retirement age.
A person might be assessed objectively as wealthy, among the top 1% of residents of her country. Yet status-seeking might lead her to perceive herself subjectively as lagging behind her aspirations. She might take risks for a chance to reach the top 0.1%, accepting potential losses that would knock her down to the bottom 20%.
Conversely, a less status-seeking person might be assessed objectively as poor, with wealth placing him among the bottom 20%, yet does not perceive himself as lagging behind his aspirations. He might not be willing to take risks and accept potential losses because he has already reached his wealth and social-status aspirations.
Whether markets are up or down, it is always a good time to discuss your goals, aspirations and risk tolerance with your advisor. If you are far from your aspirations, you might wish to accept prudent investment risk that offers a good chance to take you closer to your aspirations. But if you are ahead of your plan or have reached your aspirations, you may choose to enjoy lower investment risk, even if you can afford high investment risk.
A word of caution about reacting to strong market returns — some investors may be tempted to take on a higher risk profile or portfolio than is warranted for them because good times can mistakenly lead them to believe that they may be able to handle more risk than they really can or should. Some investors can forget that markets don’t always go up.
Remember, proper risk taking may be key to weathering the volatility necessary for long-term returns. And the best portfolio is one that helps you achieve your goals… and even more importantly, stay invested.