Knowing Your Risk Profile
Knowing how much risk you should take on and how much risk you can tolerate is often the key to a successful experience when it comes to investing. There are a number of things that go into making up your risk profile. This list is meant to help you uncover some of those ideas, but is by no means exhaustive. On the surface, it sounds like a pretty straight forward question; “How much risk am I willing to tolerate”? Another way to ask it is, “How much financial pain am I willing to endure?” The quick answer is usually is something like I want as high as possible return without much / any “risk” of losing my principle. Sound familiar?
This is why the most accurate profile is never done on yourself, as investing is emotional so most people don’t get the most accurate fell for their risk profile. They tend to overestimate or underestimate their ability to tolerate the risks that separate investing from a “sure thing”. The best risk profile assessments are done with the help of a trained professional. For the purposes of this article, we will be focusing on market risk or volatility. There are many other kinds of risk as well, (currency risk, inflation risk, interest rate risk, etc.) but when most people talk about risk tolerance they are talking about how much up and downs in the market you can stomach, so we’ll stay focused there.
Market risk is the chance your investment will go down in value. This is the risk the media often focuses most on and is most misunderstood. Most people have heard the key phrase of how to make money in the stock market; “Buy low and sell high”. While this sounds simple, it is far harder to do in real life. This risk can arise from a variety of reasons. Markets –or companies – values can move based on rumor or fact. Information – or concern – can be about the company itself or the economy in general. If this is an international company there are a host of other variables that may need to be considered. Of course, people sell securities because they have heard bad news and fear it could go down further. It is said a bear market is when large numbers of people become uneasy at one time and they all sell at once.
The first consideration of risk is time; how soon will I need this money, if ever? The longer the time frame the money has to accumulate the better. The longer the time frame, all things being equal the more investment risk most people can take on. This long time frame allows the normal ups and downs of the market cycles to take place while you maintain your longer term vision. If the asset is being added to on a regular basis (See Dollar Cost Averaging1) some volatility helps lower share price per share and result in the accumulation for more shares. As an investment goal approaches, it may be a good idea to trim the amount of risk an investment is subject to prepare for the use of the money; if the money is to be spent all at one time. If you have an investment that has to product income over an unlimited amount of time – think retirement account – it is important to remain invested and not spend more than the account can reasonable earn on a regular basis or you will run out of money.
Percentage of Net Worth
The next consideration should be a good look at the amount of your personal worth is tied up in any particular investment. A healthy investment plan will include several different investments for diversification. Think of a well-balanced meal; the meal may contain a nice steak for protein, some vegetables for minerals, and bread for grains. While you can have a meal that has only one of the food groups, it is not as healthy. Similarly, an investment plan should have investments with different objectives as well. Traditionally these are categorized as large, medium and small companies. Companies are further subdivided into companies that are a Value for their share price and companies that are Growth opportunities; ones that may be in a position to take advantage of their position in the market or a new technology. There are also investment that specialize in domestic (American only) companies and foreign as well. Foreign can be subdivided into; Europe, Asian and Latin American – some are even country specific.
There is a common thought that one should take all your money and attempt to figure out what the “next hot investment is” and that all your money should be moved to that place. This is very hard to do, and is extremely risky. A wiser philosophy is spreading your investable dollars around into many of these types of investments. Finally, on a periodic basis, it may be a good idea to rebalance the investments as each of these categories of investments will perform differently and not bringing the investments back into the original ratio can increase your risks.
*Neither diversification nor rebalancing can ensure a profit or protect against a loss.
Financial Literacy and Past Experience
Another point to consider is your own economic upbringing. People talk about risk as if there was one scale that fit all, there is not. This is entirely personal. If you were raised in a very conservative home were your parents favored a “sure thing” you may be more likely to be risk averse. This may have been fine in your parent’s economic situation but to yours it may be very dangerous. You may find investments with little or no volatility appealing and those with a higher propensity for price fluctuation – and a higher potential for earnings, even if less regular as dangerous or even a gamble. The reverse can be true as well. If you were raised in a home where risk taking was overly encouraged you may be prone to take more risk than necessary to achieve desired results.
The key to all this to separate “lore” from advice. We often hear “So and So said never do this” or “only buy that”. Those are very simple instructions, and are often lacking the background of perspective. Your parent’s situation may be very different from yours. At the time these ideas may have been formed, their economic reality was very different. The world is a very different place from the 1950s, 1980s and even the 2000s. It is important to have an advisor help you develop a plan that takes today’s economic realities into account. A retire in the early 1990s could expect a much larger portion of their pre-retirement income to come from corporate plans (pensions) and Social Security. Today’s retirees are getting much less and those who retire in the future will find it different still. The key is not to be trapped in the past.
Another big risk is experience. A body at rest tends to stay at rest and one in motion tends to stay in motion according to Einstein. This is not just a physics expression, it holds true with investors. If someone has never invested, it is not rational to expect this person to go out and develop a portfolio on their own. If they have no experience someone else will need to get them moving; help them select investments that meet their needs. Also if their experience was traumatic – think someone bought something and lost a great deal of money the expectation is that is what will always happen. People with these experiences tend to greatly underestimate their ability to tolerate risk do to fear.
On the other end of the spectrum, we find people who over estimate their ability to tolerate risk as they may never have felt the sting of loss. We saw this commonly in the late 2000s in real-estate. People bought homes thinking that real-estate only went up in value. As we saw, that does not always happen and many people who bought homes on the expectation that it would go up in value forever were wiped out because they were not aware of the potential for prices to recede in real-estate.
A qualified investment professional can be a valuable ally in helping you know your real tolerance for risk. And knowing it can help you clarify what portfolios are a better fit for your various goals and objectives.
1Dollar-Cost Averaging does not assure a profit or protect against loss in declining markets. Such a plan involves continuous investments in securities regardless of fluctuating price levels of such securities and the investor should consider his/her financial ability to continue purchases through periods of low levels.
Securities and advisory services offered through National Planning Corporation (NPC), Member FINRA/SIPC, a Registered Investment Adviser. Additional advisory services offered through Trilogy Capital, Inc., a Registered Investment Adviser. Trilogy Financial Services, Trilogy Capital, Inc. and NPC are separate and unrelated companies.