A cornerstone of any investment plan is understanding one’s tolerance for risk. A strategy with high returns is never optimal for an investor who lacks the ability to stick with it. To help you identify your tolerance for risk, we’ve developed this worksheet as part of The AAII Way (The AAII Way is a process for creating a comprehensive plan that can be your investing guide. It was introduced in the June 2020 AAII Journal). Before you read through the worksheet, we’d like to explain the logic behind it.

A few factors determine how much volatility in portfolio returns you can withstand. They are:

1. The timing of when you will need the money to spend on your goal;
2. The period in which you anticipate spending money on the goal;
3. How much money you need relative to your wealth once the goal is reached (and the first few years afterward, if the goal does not require a lump-sum payment);
4. Your psychological ability to cope with up and down markets; and
5. Your knowledge of investing.

We’ve included investing knowledge in this list because familiarity with the characteristics of investments and market cycles helps an investor to be less reactive to shorter-term fluctuations in asset prices.

The worksheet, which incorporates feedback from AAII members, is divided into two parts. The first part addresses the timing of the goal. The second part helps you to assess your psychological and financial tolerance. The answer to each question has a score associated with it. Simply enter the appropriate score in the boxes next to each question and add up your scores for each part at the end. The online spreadsheet will tabulate your scores.

To determine where you land on the grid, simply match up your timing risk score (displayed horizontally across the grid) with your psychological/financial tolerance score (displayed vertically on the grid). In a future AAII Journal, we’ll show you how these scores tie into asset allocation decisions. Alternatively, you can see suggestions at www.aaii.com/AAIIWay.

Here’s how a hypothetical couple might fill it out.

Affluent but a Bit Unnerved by Volatile Markets

Bob and Jane are recently retired (both age 66) and have $1.5 million in savings. They have non-portfolio income from pensions and Social Security.

The timing of their goal is “now” because they’re retired. Given that they are in their mid-60s, their spending time horizon is long. Bob and Jane’s wealth allows them to take proportionately small withdrawals relative to their savings. Combined, these factors result in a timing risk score of 13, which is categorized as long term.

Bob and Jane are fairly disciplined investors but have gotten a bit nervous during past bear markets and pulled back a little bit on their equity allocations. They have a guaranteed stream of non-portfolio income. They have a good understanding of investing concepts but are not experts. These factors result in a financial/psychological tolerance score of 12, which is at the low end of “high.” If they had less non-portfolio income, their tolerance score would be lower.

The combination of their timing risk and financial/psychological tolerance suggests that they can use an aggressive allocation strategy (one designed to seek long-term growth). Their wealth and the presence of a pension are big reasons why.

Try It Out and Give Us Feedback

We want what we’re creating to be useful to you. Fill out the risk worksheet and let us know what you think. Then go to www.aaii.com/AAIIWay for additional worksheets and content we’re developing as part of the process. If you have feedback you’d like to share, email us at journal@aaii.com or post a comment at the end of this article.

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