Are you the type of person first in line to ride a new roller coaster? Or can’t wait to try skydiving or bungee jumping?
If you live for an adrenaline rush, It’s safe to say that you enjoy a certain amount of risk in your personal life. But what about with your money?
All investing carries some risk, but how much risk you’re comfortable with and how much you have to take impacts your finances.
- Risk tolerance and capacity are two different things that work together to drive your investments.
- Your risk tolerance and capacity are likely to change throughout your life as your personal and financial priorities change.
- The key to a well-balanced investment portfolio is diversification.
What Risk Tolerance Is
Risk tolerance is a measurement that describes how much loss an investor is willing to have through their investments.
The amount of risk tolerance an investor has typically determines their chosen investments. For example, someone with higher risk tolerance may invest more funds in cryptocurrency, stocks, etc. On the other hand, an investor with lower risk tolerance may stick to bonds.
A person’s risk tolerance can also be affected by stock market volatility, interest rate changes, market swings, economic or political events, or personal life events.
The average investor will typically fit into one of three risk tolerance categories:
- Aggressive: These investors are more willing to lose money for significant gains. Their portfolio will likely include primarily stocks and little bonds or cash.
- Moderate: If investing were Goldilocks and the Three Bears, this would be the “just right” porridge! Moderate investors want to grow their money, but not lose too much. This is why this category is sometimes called “balanced.” Their portfolio will likely include a 50/50 or 60/40 mixture of stocks and bonds.
- Conservative: These investors want little to no risk in their portfolio. This person will commonly be a retiree or someone close to retirement age. Essentially, they’re unwilling to risk a significant loss because they don’t have time to recover. This type of portfolio would likely include CDs, money markets, or U.S. Treasury Bonds.
Now, how do you decide which category suits you best?
Discovering Your Risk Tolerance
When determining your personal risk tolerance, a great place to start is by asking yourself these questions:
- In how many years will you begin making withdrawals from your investments?
- Approximately how many years will you be making withdrawals?
- Is protecting your portfolio more important than high returns?
- Do you predict your income level staying the same, increasing, or decreasing over the next few years?
- What do you expect to be your next significant expenditure? Buying a house, paying for your child’s college tuition, providing for retirement, etc.?
Your risk tolerance level will depend on your answers to these questions. For example, if you aren’t planning on making withdrawals from your retirement savings accounts for 30 years, it’s safe to say that you likely have a higher risk tolerance than someone who’s 5-10 years away.
Other things that can impact your risk tolerance are how much you have in your emergency account, HSA savings, 529 plan savings, etc. If you have a bit of a “safety net” regarding your savings, you may feel more comfortable taking risks.
There’s another aspect to investment risk that surrounds the concept of the amount of risk you must take to make progress (gains) through your investments. That’s called risk capacity.
What Risk Capacity Is
Risk capacity and tolerance are different, but they work together to help you create an investment portfolio. Where your comfort level determines risk tolerance, risk capacity is a threshold determined by your goals.
What does this mean? If you want to increase your retirement savings by a large percentage strictly through your investments, you must invest in risky investments like stocks.
Risk capacity is the risk you must take to reach your financial goals. So, you could be a person that maybe is more of a conservative investor, personally, but your financial goals push you into the moderate category.
Risk is Unavoidable
The risk still exists even if you and your skydiving instructor take all necessary safety precautions, like triple checking your parachute. The same goes for investing.
Unfortunately, it’s nearly impossible to create a risk-free investment plan. The stock market is, in its nature, turbulent, but what goes down must come up! Even if you try to avoid potentially significant losses by “timing the market,” you could ultimately cost yourself money in the long run.
Timing the market doesn’t work. It’s as simple as that! Market timing is moving investments in and out of the market or switching funds between assets based on predictions. So, in theory, if investors can predict when the market will go up and down, they can make trades to turn that market movement into a profit.
If it sounds too good to be true, it’s because it is. Even the most committed and researched investors can try to time the market, but it’s not reliable.
Market timing is the polar opposite of a buy-and-hold investment strategy. Meaning you focus on the short-term rather than the long-term. But why is this harmful?
As we mentioned earlier, what goes down, must come up! It’s tough for investors to accurately pinpoint a market high or low until after it’s already happened. By switching your money around, you risk not having your assets back in the “right” place to take advantage of the inevitable upswing.
A J.P. Morgan study found that the best market days come right after the worst. For example, in 2015, the best market day was August 26th, two days after the worst day. This is an argument in favor of the buy-and-hold strategy. Investors usually are rewarded for sticking to the investment strategy and riding out the bad market days.
Your Risk Tolerance and Capacity Can (and probably should) Change Throughout Your Life
The amount of risk within your investment portfolio will likely change. For example, if you’re 30 years away from retirement, your focus will likely be on earning funds rather than maintaining them. Your portfolio at this phase of your life will likely include riskier investments like stocks.
On the contrary, as you near retirement, your focus will likely be on maintaining your savings rather than earning. You’ll likely move towards safer investments like bonds with lower earning potential but less risk for more significant losses.
The key to a well-balanced portfolio is diversification.
The Recipe For a Successful Investment Portfolio
The three bears could argue that this is their secret to having porridge that’s “just right.”
All solid, well-balanced portfolios have one thing in common, they’re all diverse.
We know you’ve heard the saying, “don’t put all of your eggs in one basket,” which is the same idea. You obtain a diverse portfolio by including various investments and securities from different issuers and industries.
The idea behind diversification is that if one of your investments “fails,” you have others to help ensure your portfolio as a whole remains secure.
If you have questions about your risk tolerance, capacity, or even where to start with your investment portfolio, we are here to help!
We know it’s hard to find time in your busy day to discuss financial priorities and decide about your life and financial goals. At AVID Planning, we use a unique process called our Purpose-Driven Money System that guides you to explore and gain clarity on all aspects of your lives.
Please schedule a time to chat today.