Unless you’re a teenager with a still-developing brain, risk is something you generally avoid.
Risk implies peril. Loss. Danger. Things that you’d rather not have to experience. Like a car accident. Or a bear attack. So, like most people, you follow the speed limit and you definitely don’t leave food out at your campsite.
But sometimes, (against your safe-is-better instinct) risk is good. Sometimes it can bring reward. When you’re talking about investing your money, risk is something that can (and should!) be managed so that you come out with a good return — AND your nerves intact.
Your key to a good strategy — understanding risk tolerance
The key to a good investment strategy is understanding what we in investment circles call, your investment risk tolerance. Putting it simply, this is just the question of how much risk you can handle without being rash. Every investor should know this.
If you take too little risk, (especially as a young investor where time and compound interest are on your side), you could leave a lot of money on the table. However, too much risk could put your investments in jeopardy.
What to do? A safer portfolio with potentially lower returns or a riskier portfolio with potentially higher returns?
Like a good pair of shoes, your investment strategy should fit you well. Age, income, financial needs, circumstances and your emotional make-up all play a key role in deciding what level of risk tolerance is a good fit for you.
The next four steps will help you determine a risk level that is appropriate for you — one that you can stick with, even when the markets make you twitch.
4 steps to figuring out your risk tolerance
1. How soon will you need your money?
Your investment timeline matters. Are your investments long-term? Short-term? This, of course, depends upon your goals.
People save money for different things — retirement, college, a down payment on a house, vacations and so on. If you are investing for retirement and have 30 years before you’ll need that money, you can adopt a more aggressive (riskier) investment strategy weighted more heavily with stocks and other growth-oriented investments. Most likely, you would have time to recover from any market setbacks.
However, if your money is earmarked to pay your child’s college tuition just a few short years away, more conservative, lower-risk options might be more appropriate. The potential for a higher return is less, but the risk of loss is less, too.
As a common rule of thumb, the longer your investment time horizon, the more risk you can assume. The shorter your time horizon, the less risk you can safely take on.
2. What’s the difference between risk capacity and risk tolerance — and why does it matter?
The million dollar question regarding risk actually has two parts: “How much risk can you handle, and how much risk should you handle?”
Did you know that your ability or capacity to afford losing money in the markets (risk capacity) may be different from what you are willing to risk (risk tolerance)? That’s because investing is not just about the numbers. It’s also about emotions.
Your risk capacity (what you can afford to lose) is set by your financial situation, which, of course, may change over time, depending on your goals and circumstances. If you have hefty financial obligations — like a mortgage, college bills or helping your elderly parents — your risk capacity may be lower than for a younger single person with fewer financial obligations (and decades of investing ahead of them).
Risk tolerance, on the other hand, is not always driven by your financial situation. You may be as rich as Croesus (able to handle significant loss), but if your emotional make-up is such that you reach for a bottle of TUMS whenever the market tumbles, you may not be willing to tolerate as much risk. Hey, we all need to be able to sleep at night.
And remember, for many people, what looks tolerable on paper may not feel as tolerable when the risk turns into reality.
Before you choose an investment strategy, take an honest look at how you respond emotionally to various levels of risk. BOTH your risk capacity and your risk tolerance must be carefully considered when deciding what level of risk is best for your investments.
3. Educate yourself
Get educated. The more you know about what to expect from your investments, the less likely you’ll react emotionally and panic when the markets gyrate. Familiarize yourself with your investments. Learn how they typically behave in good times, bad times and in-between times.
Understand that investments with potentially higher returns (stocks) are more volatile and riskier than conservative, less volatile investments (bonds and cash or cash equivalents) and usually require a longer time horizon to bear fruit. The more you have invested in stocks, the bumpier your ride may be — but with potentially higher returns. Conversely, the more you have invested in bonds or cash, the more stable your investment may be during times of market stress. The downside is you’ll also be less likely to achieve those higher returns when the market is up.
4. Diversify: your go-to-strategy
It’s really not debatable. Diversifying your investments among different types of assets is an important safeguard against loss. The particular mix of stocks, bonds and cash that you choose should reflect your risk tolerance level.
From the chart provided by investment research company, Morningstar, you can see (hypothetically) what conservative, moderate and aggressive portfolios typically do when invested, by differing degrees, in stocks, bonds and cash.
Let’s say at the beginning of 1970, you decided to invest $10,000 into one of the three hypothetical asset-allocation models you see in this chart. Every year until the end of 2016, you would have rebalanced your portfolio to maintain your chosen mix of stocks, bonds and cash. Given this scenario, by the end of 2016 the most aggressive portfolio would have climbed to $892,028, the moderate portfolio would have grown to $676,126 and the most conservative portfolio would have reached $389,519.
While many would naturally prefer the higher return of an aggressive portfolio, ask yourself: Could you stomach a -44.4% loss? Depending on your age, goals and financial situation, your answer may be ‘yes.’ But, it also may be a resounding ‘no!’
The point is, know yourself. Know the investment risk you can and should handle, given your age, goals, financial situation and emotional make-up.
Choose a risk tolerance level that you can stick with through market ups and downs — and still get your eight hours of sleep at night.
Advisory services are offered by Joslin Capital Advisors, LLC, an SEC Registered Investment Advisor.