Chances are, when you first met with your financial advisor, she asked you to fill out a questionnaire to assess your risk tolerance using a question similar to the following:

*“Given your financial goals, how much risk are you willing to assume to achieve your portfolio’s expected return?”*

At best, this type of question is misleading. It implies that “risk” is the same as “volatility” (short-term price fluctuations of your portfolio). Given that **“risk” **is the likelihood of permanently losing money, the correct answer to the above question is “**low**” or even “**zero**”. That is, we have every right to expect not to permanently lose money over our long-term investment horizon of 30+ years (i.e., that we end up with less money than we started).

Further to this point, the above question implies there is a trade-off between risk and reward. While this may be the case in gambling, it’s not typically the case for a long-term investor.

Using risk as a proxy for volatility will likely lead to a poorly designed asset allocation, costing you hundreds of thousands of dollars in the long term. This is because your financial advisor may create an asset allocation that minimizes the fluctuations (**volatility**) of your portfolio when your intention is to minimize permanent loss (**risk**). This will be at the expense of average Compounded Annual Growth Rate (CAGR) of your portfolio.

I’ll have more to say in a later post about the impact of CAGR on long-term portfolio value. However, as an illustration, lets’ say you invest $300/month for 30 years and achieve a CAGR of 8%. In this scenario, you’d end up with about $425,000. If we reduce CAGR to 6% (e.g., because we’ve designed a less volatile portfolio), your portfolio would be $294,000 (31% less).

### Address the Volatility/Reward Tradeoff

A truly meaningful conversation with your financial advisor should address the following topics.

- What is your tolerance for portfolio volatility? That is, the likelihood you will sell and permanently lock in your losses should your portfolio decline by (10%, 20%, or more); and
- A discussion about the trade-off between volatility and reward (long-term rate of return – CAGR).

The above should be put in context with the historical behaviour of the equity market. That is, in any given year, annual market returns have ranged from -42% to +55% over the past 90 years or so. However, over this same time period, the range of annualized returns (CAGR) for anyone investing over a 30-year time horizon has ranged from 8% to 14% (see this post).

It is only with a through and clear discussion of your tolerance for volatility that you can truly design a portfolio to suit our long-term goals. You should have zero tolerance for risk (permanent loss).