Your investments are important to you, so you know how crucial it is that you keep risks at bay. The portfolio that is right for you depends on a number of factors, one of which includes the question, How much risk you can tolerate? The ideal portfolio for you varies depending on your investment objectives and investment time horizon. Most importantly, it proactively plans for your level of risk tolerance.
Regardless of your preferences, you likely would want your portfolio to reflect risk levels you are comfortable with. No matter what level you’re at, risk tolerance will also affect your potential return on investments.
There are two questions to ask yourself when it comes to this concept:’
- How much risk are you able to manage?
- How much risk are you willing to handle?
This article will elaborate on what risk tolerance is. Moreover, it will explain the rewards that can come from taking risks and how to determine your own tolerance.
What exactly is Risk Tolerance?
‘Risk tolerance’ refers to the degree of variability in investment returns that an investor is willing to tolerate. It is a vital component when it comes to investing. Investors need a practical understanding of your ability and willingness to endure large swings in the value of your investments. If they wind up taking on too much risk, it’s possible that they may sell at the wrong time.
There is an abundance of risk tolerance assessments that are available for investors. Some of these types include surveys or questionnaires that relate to risks. As an investor, you might also wish to review worst-case returns from the past for different asset classes. This should help you get a rough idea of how much money you would feel comfortable losing if your investments experience a bad year. Moreover, if they experience a string of bad years.
Some factors that affect risk tolerance include the time horizon you have to invest, the capacity of your future earnings, and the existence of other assets. These other assets are things such as a home, pension, Social Security, or an inheritance. Generally speaking, you can take more risks with investable assets whenever you have more stable sources of funds readily available.
Three types of investors
There are three general approaches to risk tolerance that may investors take: Aggressive, Moderate, and Conservative. To elaborate, aggressive investors reach for maximum risk and conservative investors want full predictability in their investment portfolio.
- Aggressive: These are investors that have a tendency to be more market-savvy. Possessing a deep understanding of securities and their weaknesses allow these individuals and institutional investors to buy highly volatile instruments. These include small company stocks that are susceptible to dropping to zero, or options contracts that can expire. While preserving a foundation of lower risk securities, aggressive investors reach for maximum returns with maximum risk.
- Moderate: These investors tolerate some risks to their principal. However, they embrace a more balanced approach with intermediate-term time horizons of 5 to 10 years. By integrating large-company mutual funds with less volatile bonds and low-risk securities, moderate investors typically seek a 50/50 structure. A common strategy involves investing half of the portfolio in a dividend-paying, growth fund.
- Conservative: These investors accept next to no volatility in their investment portfolios. Retirees whose nest egg has taken decades to build are against putting their assets at risk. A conservative investor frequently targets vehicles that are made guaranteed and that are also highly liquid. So, individuals that are risk-averse elect for other factors. These include bank certificates of deposit (CDs), money markets, or U.S. Treasuries.
Capacity: What’s the difference?
There is another term in investments that sounds similar to risk tolerance, and that is ‘risk capacity.’ While on the surface, these concepts appear to mean the same thing, they actually have different meanings.
Unlike risk tolerance, risk capacity is the amount of risk that the investor must take in order to achieve financial goals. You can estimate the rate of return crucial for reaching these goals by analyzing time frames and income requirements. Following this, the rate of return information can help the investor decide upon the types of investments to engage in. Furthermore, it helps them determine the level of risk to take on.
It’s important to calculate the income targets first. This is so that a decision can be made regarding the amount of risk that may be required.
An issue that many investors face is that their risk tolerance and risk capacity are not at all similar. Whenever the necessary risk exceeds the level that the investor is willing to take, a shortfall will typically occur. This shortfall correlates with reaching any future goals. Be that as it may, when risk tolerance is higher than necessary, the individual may take the needless risk. These particular types of investors often have the name of “risk lovers.”
There is a good amount of self-discovery when it comes to taking the time to understand your personal risk situation. Moreover, there is a substantial amount of financial planning. While procuring your personal and financial goals is possible, there’s the matter of personal feelings surpassing reason and judgment. So, it would be beneficial for you to work with a professional.
Rewards & Risks
Risk and reward share a close connection when it comes to investing. The best way to look at it is to take the phrase “no pain, no gain” into consideration. That timeless motto is the best representation of the relationship between risk and reward that you are going to get. Pretty much all investments involve some semblance of risk. If you are planning on buying securities (stocks, bonds, mutual funds, etc.), then it’s important to understand that you could lose your investments.
The reward for taking risks is the potential for a significant return on investments. If your financial goal has a long time horizon, you may make more money by investing in higher-risk assets. Just so long as you invest in those assets very carefully. These higher-risk assets include stocks or bonds. All in all, you may rake in more money doing this than if you limit yourself to less risky assets. On the other hand, lower risk cash investments are comparatively more suitable if your financial goals are short-term.
To bring back two of the investor types from before, an aggressive investor has a high-risk tolerance. They are willing to risk losing money in order to garner potentially better results. A conservative investor is one with low-risk tolerance. They prefer investments that sustain their initial investment.
There are many investment websites that offer free online questionnaires that help evaluate your risk tolerance. Some of the websites even predict asset distributions by drawing from questionnaire responses. The asset allocations they suggest are usually a helpful starting point, but remember that the results may have a bias. That is to say, they may lean more towards financial products or services that the website sponsors are selling.
Now that we have clarified what risk tolerance entails, it’s time we look into the components that make up the concept. There are four of them and they will be presented as steps.
Step 1 – Determine your investment time horizon
This is arguably the most important part of determining your risk tolerance. It’s crucial that you know how soon you expect to need the money that you are investing in. If you need the money within a month’s time, then you should invest far more conservatively then if you won’t need that money for several decades. This is primarily due to stocks being considerably volatile in the short-term.
You have to pick a portfolio that fits your needs. It’s incredibly risky to select a heavily stock-oriented portfolio if you need to have the money within months. Likewise, if you’re investing for the long-term, then putting money in cash is essentially a waste. With cash, there is little risk of a large fall in value. However, it’s unlikely that your investment will rise in value and consequently, inflation will deteriorate it. Ultimately, how long you are investing for is a key part in determining risk tolerance.
Step 2 – Take your own ability to withstand weak markets into consideration
A second important factor is your own ability to get through bad markets. Superficially, this may sound like something simple, seeing as how markets usually bounce back after a declining period. However, when looking at a lot of red ink across your portfolio, it can be difficult to stay on course. This can end up seriously hurting your returns.
For example, during the 2008-09 market declines, numerous investors could not handle the daily losses they saw in their portfolio. As a result, they moved to cash. Unfortunately, many of them never made the move back into the market. Thus, they missed out on the S&P 500 tripling in value off the lows during the following years. For this reason, it is important to have a distribution you have conviction in and losses you can endure.
Step 3 – Contemplate your other income streams
This factor in relation to risk tolerance is your personal ability to earn money. If you have a steady job that pays well, it is possible that you can take a little more risk. This is because you are not depending on your investments as your singular source of income. With that in mind, if you are a retiree and you no longer earn an income, then you should take fewer risks. Should the market suddenly fall, you have no identifiable way of finding additional funds from income.
Step 4 – Seek out an asset allocation that reflects your risk tolerance
To sum up, when you are considering your risk tolerance, you should also take the following into consideration:
- Time horizon
- Ability to handle and withstand price declines
- Ability to earn money beyond your portfolio as soon as you have an idea of where you stand with risk tolerance
FutureAdvisor is a platform that can help you construct a portfolio for you that aligns with your age and risk tolerance.
Some of us are more than willing to take on risks while others wish to deal with it as little as possible. Regardless of which side you lean towards, one cannot deny the importance of determining each of our risk tolerances. For the good of our investments, it would be wise to figure that out sooner rather than later.