What is the right investment risk for me? What is my risk profile or risk tolerance? This is one of the most important topics for any investor as they formulate and implement their investment strategy. Even if you are working with a financial advisor, you will need to give consideration to and provide information for your sensitivity to investment risk. The amount of risk you take in your investment portfolio has the potential to alter your outcomes and determine whether or not you reach your financial goals. Additionally, after working hard to generate the savings to invest, you need to ensure that you are not taking financial risks with which you may be uncomfortable. You do not need to be an expert in investing to have a basic understanding of how to determine your risk tolerance. This is also one of the best ways to ensure that you are on the same page as your financial advisor in selecting the right type of investments for your portfolio. Once you’ve determined your risk tolerance and communicated this with your financial advisor, they are obligated to ensure your investment portfolio falls within those standards. There are a number of considerations in determining the amount of risk that is appropriate for you, and we’ll break those down here.
Investing your hard earned savings inherently comes with risk. In very general terms, this investment principle is referred to as the risk-return tradeoff. According to this principle, if an investor is willing to take on more risk (potential for higher losses and higher profits), then the investor has the potential to generate a higher return. It is important to understand that taking on higher risk can lead to larger outcomes for losses as well as gains. As a practical matter, this can be broadly illustrated by comparing stocks with bonds. At a high level (and using historical data), stocks carry more risk than bonds. While bonds are safer, and thus do not fluctuate up and down as much as stocks, they also tend to yield a lower investment return than stocks over the long run. Stocks on the other hand can gyrate up and down quite significantly, leading to relative short-term periods of lower performance while materially outperforming bonds over the long haul.
As you’ll see with the discussion of specific factors below, much of the determination for your risk tolerance is based on personal factors. It is thus a personal decision. What may be best for someone else may not be best for you. While it can be helpful to discuss risk as a concept with friends and family, it is important to always remember to make your own determination based on your own specific characteristics and preferably with the guidance of a financial professional. Additionally, these characteristics can and likely will change over time as your life changes and moves through various stages. Periodically reevaluating your risk tolerance is prudent, and you should always promptly communicate any changes in writing to your financial advisor. While each of the below factors is important, you should balance all of them in determining the right fit for you.
Factors to Consider in Determining Investment Risk Tolerance
With different ages come different stages of life, and with that, potentially differing investment time horizons. As a general matter, the younger a person is, the more risk they can afford to take. As someone ages, the less risk they can afford to take. A great example of this relates to planning for retirement. Using the assumption of retiring at age 65, we consider the effect of age on risk tolerance. Someone who is 25 and expects to retire at age 65 has a forty year time horizon before they will need their retirement savings. Compare that to someone who is age 60 expecting to retire at 65. The 60 year old only has a five year time horizon for using their retirement savings. The 25 year old can afford to take on more investment risk because if the investments go down in value in the short-run they have ample time for the investments to potentially recover and grow. Conversely, the 60 year old does not have this amount of time. They would generally need to consider a lower risk portfolio in an attempt to avoid a big downturn prior to using their retirement savings.
Time horizon is often discussed with the age factor above. However, it is not solely related to age. Simply put, investment time horizon is the amount of time you will have the funds invested before utilizing the funds for your stated financial goals. This can vary widely depending on the goal in mind. For example, our 25 year old and 60 year old in the example above each have different time horizons for the same goal of retirement. However, a different 60 year old may determine they can meet their retirement needs based on their pension and social security income. Thus, they may determine their additional savings will be passed on to their heirs and thus maintain a long-term time horizon for those funds. Other common examples are funding for education, a home down payment, second home, or other large financial expenditure. These examples may all carry their own timelines in the mind of the investor. Understanding the specific goal for the money, will help you to determine what investment time horizon you have for those funds.
Knowledge & Experience
Your personal knowledge and experience with investments plays into the appropriate risk for your portfolio. It is always prudent to avoid putting your money into investments with which you have little to no understanding. This does not mean you have to be an expert in every security you purchase. But it does mean being able to ask the right questions, and understand the risk factors that will affect that position. In this case, the less knowledge or experience you have, the less risk you should take on.
Assess Your Goals
Investing should first and foremost be about what goals you are targeting, whether that be retirement, education, home purchase, leaving assets to your heirs, etc. To quote the late Zig Ziglar, “If you aim at nothing, you’ll hit it every time.” Why take on more risk with your money than necessary to reach your financial goals? Consider and formulate the financial goals you are trying to achieve. This will help to determine what it will take for you to get there from where you are now. From there, you can see how much risk is required to get from point A to point B.
Your current financial situation plays a major role in your ability to take on risk. Someone who has a stable income, low debt and ample savings can take on more risk than someone who does not have those factors. If you might need the funds at any time because you do not have a stable income or ample savings, then you generally should not take on higher levels of risk. Remember, more risk means more volatility (or fluctuation up and down). Because you don’t know when you may need the money, you cannot ensure that your timing will match the timing of the market and avoid taking losses during the downs.
Personal Comfort with Risk or Risk Profile
Each person views risk through a different lens. Your personal comfort level with investing and taking investment risk will play a major role in determining the appropriate risk tolerance for you. Call it the sleep-at-night factor. Are you up all night worried about what your portfolio is doing? Then you may not be investing with the proper risk tolerance. Everyone is wired a little differently, and some are more comfortable with taking risk in life. Others are not. This is reflected in daily decisions we make throughout our life. Investment risk is no exception. Think through your own personal views of taking risk and apply that to how you consider your investments.
Seek Professional Advice
Last, but certainly not least, it is always best to have the discussion about investment risk with the guidance of a financial professional. They can help you consider the full framework for determining the most appropriate level of risk for you. They can answer questions and provide feedback to your thought process. And, for those who utilize a financial professional to manage their portfolio, it is crucial they have a good understanding of how you consider risk, and correspondingly, how they should be managing your accounts.