“Know thyself.” -- Socrates
An important tool for any investor is inside information. By “inside information” we mean knowledge about yourself. Knowing your goals, emotions and financial circumstances helps you create an appropriate investment portfolio and helps keep you on track over the long term.
What is your risk tolerance?
A personal trait of every investor is his or her risk tolerance. Essentially, it is a realistic assessment of the level of risk you’re comfortable with in your portfolio.
Your risk tolerance is a key factor in selecting the mix of investments in your portfolio, known as your asset allocation. How much you have invested in stocks is generally a representation of your risk tolerance. Stocks are generally riskier than bonds. Therefore, the more you have allocated to stocks, typically the higher your level of risk.
In addition to your emotional fortitude, there are several components of risk tolerance that can help determine how much risk is right for you.
The 4 components of risk tolerance:
1. Your emotional comfort with risk
Your emotions are difficult to quantify. You may not know how much risk you can handle until you experience a market downturn. The goal is to avoid exposing yourself to a level of risk that causes you to abandon your investment plan, which can reduce the chances of achieving your financial goals.
A simple, albeit unscientific, way to test your feelings toward risk is to imagine a severe market decline. Subtract various percentages off your portfolio balance. How much can you withstand losing in one year? 5%? 10%? 30%?
2. Your time horizon
When you expect to achieve your goal, or your time horizon, is an indicator for how much risk you should have in your portfolio. Take retirement, for example.
Younger workers have many years before retirement. They can withstand a higher level of risk as their portfolios have more time to recover from any potential losses. In addition, younger workers have a greater need for risk because their assets must grow.
Conversely, investors in or near retirement should have lower risk tolerances. They are withdrawing from their portfolios, which makes it harder to recover, and they can no longer simply earn more income. At this stage, the objective should be asset preservation rather than growth.
3. Your ability to take risk
The amount of risk you are able to take pertains to how much you have in your portfolio and how much you have to invest in the first place. How much can you afford to lose without jeopardizing your financial goals? Do you have money left over after expenses to save and invest?
4. Your need for risk
Depending on your financial goals, you may need to accept a certain level of risk in order to generate enough growth. Again, this also depends on how far you are from reaching your goals.
Essentially, all investors should take a minimum amount of risk to beat inflation, which historically has been around 3%. You don’t want to be so risk-averse that your buying power continually decreases.
When to adjust risk in your portfolio
For most investors, the only reason to adjust your risk is when you near your financial goals or your financial circumstances significantly change. However, investors who find themselves feeling uneasy when the market fluctuates may want to consider lowering their risk.
You risk tolerance provides an inside look into what it’ll take to reach your long-term financial goals. But when it comes to determining your risk tolerance or how much risk makes sense for you, it helps to get an outsider’s opinion by a financial adviser.
