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.
Because investing is emotional, the most accurate risk profile assessment is never done on yourself, and that is why risk profile assessments are done with the help of a trained professional. In this article, we will be focusing on market risk or volatility. Market risk is the chance your investment will go down in value. 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.
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. 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 wise idea to trim the amount of risk for that investment preparation of using the money; if the money is to be spent all at one time. If you have an investment that must produce income over an unlimited amount of time – think retirement account – it is important to remain invested and not spend more than the account can reasonably earn on a regular basis, or you will run out of money.
The next consideration should be to look at the amount of personal worth that is tied up in any investment. A healthy investment plan will include several different investments for diversification. Traditionally these are categorized as large, medium and small companies, and then further subdivided into companies that are a “Value” for their share price and companies that are “Growth” opportunities. There are also investments that specialize in domestic (American only) companies and foreign as well.
There is a common thought that you 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, However, 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.
Another point to consider is your own economic upbringing. People talk about risk as if there was one scale that fits 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. 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. Your economic reality may be very different today than your parents was years ago. It is important to have an advisor help you develop a plan that takes today’s economic realities into account.
Another significant risk is experience. If someone has never invested, it is not rational to expect this person to go out and develop a portfolio on their own and they should seek the expertise of a professional to get started.
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.