Assessing Your Needs
How much risk are you willing to take in order to achieve your Investment goals? How much risk can you afford? Both questions are key to determining proper portfolio asset allocations.
At Cardiff Park we believe risk tolerance analysis is essential for sound financial planning, and is the cornerstone of our customized portfolio design services. We ask our clients to complete two questionnaires. The first serves to assess risk tolerance. The second allows us to assess risk capacity. If there is a mismatch between your goals and risk tolerance—for example, you have ambitious goals but are risk averse—then together we’ll find a trade-off involving an adjustment to the mix of risk taking, savings, and portfolio goals.
Let’s take a closer look at risk tolerance and risk capacity. Risk tolerance measures emotional comfort with respect to your financial risk. Risk capacity evaluates the extent to which you are poised to suffer financial setbacks. Risk capacity is defined by each client’s personal and financial circumstances. It takes into account net worth, age, investment knowledge, taxes, time horizon, liquidity requirements, current and probable future cash flows, pension benefits, regular and retirement assets, insurance, retirement account contributions, and other relevant facts.
Probability analysis is an important tool for visualizing portfolio risk against real-life circumstances and formulating an overall investment strategy. This process generates a distribution of outcomes and can be used to evaluate how a variety of alternative portfolios might support your goals. We can explore “what if” questions such as changing jobs, exercising stock options, saving for tuition, maintaining a stable standard of living in retirement, downsizing your home, moving to a lower tax state, deciding when to activate social security, and leaving a legacy.
Inputs into this analysis include the expected rate of return, the expected volatility of returns, expected inflation, anticipated savings and withdrawal rates, and retirement date. Inheritances, business equity, home equity, and the prospect of working in retirement can all be included. Different portfolios can be evaluated, ranging from the most conservative with 100% of the portfolio allocated to fixed income Investments, to the most aggressive with 100% allocated to equity Investments.
Reports can also include detailed cash flow projections with portfolio rates of return, withdrawals, savings, spending, taxes and probability analysis. In real life, unforeseen personal circumstances, inflation levels, or unusual levels of volatility and uncertain stock and bond returns introduce some degree of uncertainty into investment results. Because of this uncertainty, we open our analysis to multiple sets of simulations with different sets of inputs. Without this kind of sensitivity analysis we have no idea how different the results might be with changes to the input. Experience demonstrates that results can change quite a bit.