Reaching Financial Goals Beyond Your Risk Tolerance

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By Leland B. Hevner
President, National Association of Online Investors (NAOI)

Overview: In this article I discuss why investors should not limit their financial goals based solely on their risk tolerance assessment.

A goal of financial advisors today is to design portfolios that match the risk tolerance of their clients. Thus, the design process starts with a questionnaire aimed at assessing your capacity to assume risk and your feelings toward risk. The answers enable your advisor to assign to you a risk tolerance level that can range from conservative to moderate to aggressive.

Advisors then use an approach called Modern Portfolio Theory (MPT) to determine an optimal allocation of money to asset classes, mainly stocks and bonds, that matches your risk level. More aggressive portfolios get a higher allocation to stocks and have a higher expected rate of return. More conservative portfolios get a higher allocation to bonds and have lower expected returns.

The table below shows an example of how risk tolerance levels translate into Expected Returns. For this example I have used a 16-year historical data period from 2003 to 2018.

Most individuals simply accept the Expected Returns related to their assigned risk category and plan their financial future based on them. But where in this process do an individual’s financial goals play a role? They don’t. As a result, too many people set investing goals that are unnecessarily low.

Starting with Your Goals, Not Your Risk Tolerance

The NAOI teaches a different approach for starting an investing career. We first ask our students to think about, and quantify, the financial goals that they really want to achieve in life – goals that excite them and for which they are willing to devote time and effort to meet. We then show them multiple pathways for reaching these goals, regardless of their assigned risk tolerance level. Let’s look at an example of how the NAOI approach works.

An Example

Let’s assume that you are a 40 year old individual with a goal of having one million dollars in your retirement account at age 60; twenty years in the future. You currently have $40,000 in your account and you contribute $200 per month to it. Your advisor has assessed your risk tolerance as Moderate so your expected annual return is 8.40% as shown in the table above.

Will this return enable you to meet your goal? If not, what can you do to reach it? Changing your risk tolerance is typically not an option.

Using NAOI Financial Planning Calculators

To answer these questions we turn to a set of calculators created by the NAOI and available for free on our site at www.NAOI.org/calchome. Start with the “NAOI Wealth Accumulation” calculator found at this link and fill in the blanks with your data as shown below.

When you click the “Calculate” button the value of your account for various time periods in the future is displayed. Below is the relevant section of this table. The middle row shows the total wealth accumulation for your 20 year time horizon based on your parameters.

This total is far below your goal of having $1,000,000 in your account at the end of 20 years. So what can you do?

The NAOI “Return Required” Calculator

The NAOI teaches that the next step is to use a unique calculator called the NAOI “Return Required” calculator found at this link and demonstrated below. It shows the Average Annual Return needed from your portfolio to reach the goal you have set.

The calculator uses as input your goal and related data as shown below to the left of the “Calculate” button. The data to the right of the button are the Required Return to meet your goal and the exact Final Total of money you will have at the end of your time horizon. The blue numbers are inputs and the green numbers are outputs of the calculator.

The calculator shows that based on your input data you would need an annual average return of 16.6% to reach your goal; almost double the 8.4% that your risk tolerance level says you can expect to earn. This obviously doesn’t work. But using this calculator you now have options for lowering the Required Return % without increasing risk; namely changing your Number of Years until money withdrawal and/or your Monthly Deposit $. Let’s look at examples of changing each.

Changing the Time-Horizon

The data inputs illustrated below show that by extending the number of years until you start taking money out of the account from 20 years to 22 lowers the Required Return to 14% per year.

This is better, but still not enough to reach your goals. You can continue to increase your Number of Years or change another variable as discussed next.

Changing You Monthly Contribution to the Account

You can also lower the Required Return by increasing your Monthly Deposit $. A change from $200 to $300 is tested in the example below. Now the Required Returns is down to 13.2%. Still not close to your goal.

Note: To find how to free up money to use to increase your monthly deposit use the “Hidden Expenses” and “Money Available for Investing” calculators found on this page.

Keep Testing

You can continue changing these two variables to lower the Required Return to match your risk tolerance Expected Return. But to get it to 8.4% would require values for these variables that would probably not be acceptable. For example, you would need to extend your time horizon to 30 years with a $300 per month contribution to get it down to 9%. So what can you do now? The NAOI offers one more option to consider.

Holding a Dynamic Portfolio

Of course you can always lower your Goal $ and find an acceptable set of variables that will enable you to reach it using a standard MPT portfolio. But at the NAOI we want this to be your last option.

So we next suggest that our students step outside of the MPT “box” and consider using an alternative portfolio design and management method called Dynamic Investment Theory (DIT) that I discuss at this link.

DIT shows how to create a new investment type called Dynamic Investments that periodically sample price trends of ETFs that track indexes for both the Total Stock Market and the Total Bond Market. On a quarterly basis the DI buys, or retains if already owned, the one ETF that is trending up most strongly in price. When a DI is included as a building block in an MPT portfolio structure, the portfolio immediately becomes “dynamic” and “market-sensitive”; capable of automatically changing its asset allocations based on current market trends.

An Example Dynamic Portfolio

Below is an example of a Dynamic Portfolio structure. It has buy-and-hold Stock and Bond components with the allocations shown in the diagram plus a Dynamic Investment (DI) that alternates between a Stock and a Bond ETF based on a periodic review of the price trend of each. No subjective decisions are required to make this change and the process can easily be automated.

This portfolio is “asset-fluid”. At any one point in time it will hold an allocation of either 75% Stocks / 25% Bonds or 25% Bonds / 75% Stocks. These asset allocations DO NOT depend on your risk tolerance; they depend on current asset price trends. Dynamic Portfolios strive to hold an asset allocation that at all times is biased toward the asset class that is trending up in price.

A Higher Return Option

The table below shows the performance of this simple Dynamic Portfolio for the time period from 2003 to 2018. Compare it to the performance of the portfolios created based on risk tolerance levels shown in the first table of this article. You will see that not only does this portfolio produce higher returns than the “Aggressive” portfolio; it also has lower risk than “Conservative” portfolio. Only by stepping outside of the MPT “box” are higher returns possible without higher risk.

Below, then, is one set of inputs to the Return Required calculator that meets your goal when holding a Dynamic Portfolio. You can see that its Expected Return % matches the calculated Return Required % to enable you to have $1,000,000 in your retirement account 20 years in the future.

Of course past performance does not guarantee future results but the logic supporting this approach and the backtest data is compelling.


The NAOI believes that the results of a risk tolerance questionnaire should not define the financial goals that investors can expect to reach in life. Goals should be defined by the individual investor and then alternative pathways for reaching them should be presented by advisors.

In this article I have shown the variables that can be changed to create these pathways and the online calculators needed to structure an investing process that enables individuals to meet their goals; regardless of their risk profile.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Leland Hevner

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