How to Increase your Risk Tolerance Part 1: Ability


Ability to take Risks

Welcome back to another installment of my series on risk.  Today, we are going to discuss steps to increase our risk tolerance by focusing on our financial ABILITY to do so.

In case you missed, you can read about some risk basics HERE and how risk affects women differently HERE.

As mentioned in our previous article, risk tolerance is comprised of Ability and Willingness.  Ability is more about numbers and less about feelings. Ability lays the foundation for looking at risk, taking on risk and evaluating risk.
So let’s get started.

There is a popular framework for assessing risk tolerance in the financial industry.  It goes by the acronym of T.U.R.T.L. Which stands for Time, Uniqueness, Risk, Taxes and Liquidity.  Ability relates to all of these except “Risk” – which in this case means comfort or willingness to take risks.  Because Willingness is a more complex issue, I will write a sperate article specifically for it. Stay tuned!

Time is the clearest of them all – time meaning how much time do you have until you need the funds.  So if we are talking about retirement funds and you are in your mid 30’s, you won’t need these funds for at least 30 years.  So you have lots of time.  The more time you have, the greater your Ability to take risks.

If you are saving for a down payment on a house and you want to buy this house in the next 3 years, then you have less time.  With few exceptions, a shorter timeline means you have to be more conservative and take fewer risks.

Pro Tip 1: The longer the time before you need the money, the greater your ability to take risks with it.

Next comes Uniqueness or Unique Circumstances, this is where personal finance gets personal.  Maybe you need to take care of your parents or have a child with special needs.  Those will limit your ability to take risks.

Or maybe you are in a double income household and have already paid off your mortgage.  In this scenario, you can afford to take on more risks because your fundamentals are well taken care of.

Pro Tip 2: Evaluate your circumstance and see if you have near-term cash needs.

In terms of Taxes, it refers to your tax situation and also if the investments are in taxable or non-taxable accounts. For us, it is a generalization that we should prioritize tax-advantaged investments accounts for long-term financial goals.

Why? Investing is based on the idea that we should be paid for taking on risk.  Riskier investments should offer better returns. If you use a tax-advantaged account to buy riskier investments, you are not going to pay taxes on the gains until you withdraw the funds, hopefully when you are in a lower tax bracket like at retirement.

Pro Tip 3: Take advantage of all tax-advantaged accounts for long-term investments.

The final factor is Liquidity. This is the factor that most people underestimate. But luckily, this is the factor that is most within our control.  We can’t change our age or our unique challenges in life, but how much we can exert some control over our expenses.

This is where several financial concepts collide.  Old adages like “Spend less than you make” or “Save for a rainy day”.

Cash flow is the foundation for any financial plan

By now, we have all heard about the common occurrence of people living paycheck to paycheck and not having enough saved for a $400 emergency. What they are saying is these people have no liquidity.

We have also heard of anecdotal stories of how a relatively small emergency spiralled bigger and bigger.  In the end, it costs way more to get out of than the expense was in the first place.

Pro Tip 4: The more emergency plans you have in place, the greater the amount of risk you can take. 

This is why a lot of personal finance advice starts with building an emergency fund.  Having one, you can take care of bills that might come up.  It could be serious financial hardships like unexpectedly losing a job, or it could be relatively small items, like taking your cat to the emergency vet.

By having cash on hand for these, you don’t have to sell or disturb any investments and they can continue to work for you on long-term goals.

This is also where debt fits into the financial picture.  Whether it is student loans or it is a mortgage payment, there are severe penalties if you can’t pay, even if it is just timing.  Maybe you can pay next month, but not this month. The lender doesn’t care, they slap on fees and interest that ends up costing you more.

Some people have asked why I’m so concerned with liquidity since I have assets? Net worth numbers and assets are important, no doubt.  But remember all those banks that went bust in 2008?  It was all because they had no cash flow.

But wasn’t it about complex things called CDOs or whatever?  Yes and No.  Those complex structures did get them in hot water, but banks like Washingon Mutual, Bear Sterns, Lehman Brothers & Merrill Lynch all had to be bailed out because they didn’t have enough cash coming in to match what they had to pay out.  When they needed to, they couldn’t sell the assets they had. During that time, no one was buying anything. In the end, they had no choice but to sell themselves to bigger banks or they went into “liquidation”.

Having assets can be like a valuable beanie baby collection.  Depending on the timing, there could be no buyers. But you still have bills to pay.

Increase Your Ability to Take Risks by:

So to recap and for those of you who likes to scroll to the bottom: factors that increase your ability to take risks are 1) separating the money you won’t need for a long time from the ones that you need sooner (to buy a house or a car), 2) set up cash buffers for unexpected items, 3) increase the amount between income and expenses to ensure you have liquidity.

Just like multi-tasking isn’t productive, we don’t want our money to multitask. We want our savings to bail us out in an emergency. We want our investment money to focus only on making our long-term goals come true.

Once you are on your way with these steps, we can assess your Willingness to take on investment risks and figure out what kinds of investments fit into both categories.

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