Understanding your personal risk tolerance is a key component of savvy investing. Risk tolerance refers to the degree of a loss and variability that you are willing to withstand in your investment portfolio. Do short-term losses cause you to immediately panic? Can you brush off dips in an unstable market? Your answers to these questions may give some indication of your tendencies as an investor, however there are many factors that shape overall risk tolerance. To discuss risk tolerance, financial professionals will often refer to aggressive, moderate, or conservative investors:
In addition to these three categories, there are additional classifications in between each and even a couple that are more risk averse than conservative. There is certainly no ideal risk tolerance, and every disposition comes with potential advantages and disadvantages for investment. By understanding your own risk tolerance, you can make the right investment decisions for your portfolio and work towards your long-term financial goals with confidence.
Risk tolerance is determined by a complex array of factors for each investor. It comprises both the emotional tolerance of an investor (what degree of loss are you willing to cope with) as well as financial risk tolerance (what degree of loss can your finances withstand without jeopardizing your goals). Your age, retirement goals, personality, and liquidity needs will all shape the degree of risk you can withstand as an investor. Your relationship to the following risk factors will help you understand your own tolerance as an investor:
We all have unique personality traits that incline us to make investing decisions based on certain emotional tendencies. A competitive, risk-taking investor may be prone to making big investing decisions when they are feeling excited and exuberant. When the market is up, these aggressive investors often want to dramatically increase their investment or add more sophisticated financial products to their portfolio. On the other side of the coin, a conservative investor is predisposed to making major investment decisions out of fear. When the market takes a dip, their first reaction is to panic and pull money out of investments, even if they rationally know that downturns are inevitable and temporary. Understanding the emotions that drive your risk tolerance can prevent you from making rash, illogical investment decisions that will hurt the health of your portfolio.
As you get older, even short-term investment losses will become riskier for your portfolio because there is less time to recoup your losses when the market takes a hit. Similarly, your retirement timeline should impact your risk tolerance. If you plan to start living off your investment distributions in the next three years, you may have a lower threshold for withstanding losses compared to someone who is ten or fifteen years away from retirement. As you age and near retirement, consider steadily reducing the amount of risk within your portfolio over time.
Market risk is the most well-known type of a risk within a portfolio. Markets go up and markets go down, and your portfolio will be affected by these market shifts to varying degrees depending on its composition. To get an idea of how much market risk your portfolio contains relative to an appropriate benchmark, look at the historical performance of a portfolio built with the same combination of assets per the equivalent indices over a set period of time. Specifically, the standard deviation of an investment will measure its variation over time. If an investment has a large standard deviation, then it tends to have greater gains and greater losses during an average period of time, and thus more risk. An investment with low standard deviation tends to be more stable with less potential for significant returns or losses. The market risk of your portfolio will also increase when your portfolio is not diversified.
Liquidity risk comes from the ease (or lack thereof) with which an investor can quickly sell off an investment and convert its value to cash. Investment liquidity is an important consideration for retirees who may need to sell an investment, particularly a declining investment, in exchange for cash to meet their immediate financial needs. For example, a $600,000 home is a hugely valuable investment, but if the real estate market is down, you could find it very difficult to find a buyer at that price. In the event of a serious market downturn, certain assets such as real estate and private equity contain a high-liquidity risk which make them difficult to sell off quickly unless you are willing to sell at much lower price.
Similar to liquidity, marketability refers to the ability of an investment to be quickly traded. If an investment has high marketability and liquidity risk, there is a higher chance that you may be stuck with investment for a while when no one is interested in buying it or trading for it. For investors who are patient and focused on the long-term, high marketability or liquidity risk may be less of a concern. However, some investors cannot stand the idea of investment that they cannot quickly get in and out of. Liquidity and marketability risk is a critical consideration for retirees or soon-to-be retirees as they often cannot afford to simply wait for the market to improve while they are stuck with unsellable or untradeable investments.
Inflationary risk refers to the risk that your investment’s purchasing power will decline over time. If the value of your investment does not adjust with changing inflation rates, then its cash flows may be worth less in the future. Bonds come with a relatively high inflationary risk because they have a fixed yield (or coupon rate) that does not increase with rates of inflation. Imagine that you buy a 20-year bond that pays a 4% rate. If the inflation rate suddenly spikes to 9%, your investment will be worth significantly less in real dollars.
There are certain securities, such as the Treasury Inflation Protected Securities (TIPS) designed to address inflationary risk by adjusting cash flows for inflation. These protections can help ensure you get a real return on your investment. It’s important to understand and minimize the degree of inflationary risk within your portfolio to make sure your investments will provide the purchasing power you need.
Risk tolerance is a fundamental component of strategic investing. The more familiar you become with your own risk tolerance, the better decisions you will make when allocating your investment assets. To get a professional assessment of your risk tolerance and review the health of your portfolio, talk with an advisor today.