Everything in life has its risks, and we have all heard the old adage, "the bigger the risk, the higher the reward." While most of us are wired to think we want the most significant reward possible, that isn't always true, especially when investing.
The stock market is known for its volatility, which is one of the many reasons it is essential to determine your risk tolerance. While you might end up with the most significant reward, you could also end up with substantial losses.
Risk tolerance and investment objectives are the two most important things to know before you invest:
Risk tolerance is the degree to which you can handle variability, or "swings" in your assets' value, not just financially but also psychologically. How much risk are you able to stomach and not lose sleep at night? (I don't know about you, but I already have enough thoughts racing through my brain and don't want to add any more fuel to that fire.)
Age and investment timeline are also discussed when talking about risk tolerance; they are vital pieces of information when determining your tolerance level and creating your financial plan.
However, many other factors, including your investment objectives, are crucial when creating your plan...
Investment objectives are the "why" of your investments, and risk tolerance is the amount of time and volatility with which you can be comfortable. These are two vital pieces you need to think about before investing.
Let's take a look at these and a few other very important risk tolerance factors:
Timeline: When will you need to access the money from your investments? Retirement is a common goal on just about everyone's timeline. However, you may want to plan for many other purposes and milestones on your way to retirement, and certainly after entering retirement.
Think about it; If you have 30 years until you retire, you can take more considerable risks than if you were to be retiring in 10 years or less.
Goals: What are your aspirations for the use of the money from your investments? These are your investment objectives, your "why" for investing. Every person and the life they are living is unique to them. Even partners sharing their lives have different goals and aspirations, and each should be considered within their financial plan.
You want your money to last longer than your lifespan of both you and your partner; you most definitely don't want to run out of money in your retirement years.
Beyond that, let's go further: What are your financial goals before retirement, during retirement, and after you have passed?
Going back to your timeline, what are your goals in the short term for which you will need money?
- Are you saving to buy a house or renovate your current home?
- Do you need a new vehicle, and how often do you plan on upgrading or replacing it?
- Are you thinking about buying land?
- Are you starting or already own your own business? How much money will you need to cover the overhead costs?
- Do you need funds for childcare?
- Do you need to prepare to pay for long-term care for a loved one or yourself?
- Do you need to save money for school tuition?
"Where do you see yourself in five years?" is a question that makes many people sweat, but, as you can see from the examples above, you may need some more reliable, liquid investments for your short-term needs, even if you are younger.
The sooner you start planning for your needs, the more prepared you will be.
Age: How far from retirement are you? If you are young, you should be able to take on more risk in your portfolio because you have more time to make money work for you and can handle fluctuations in the market. Remember: the market will always go up and down, but with more time, you can readjust the strategy and allocations if needed.
If you are an older investor, you want to protect the nest egg you have saved throughout your working years. When you need to cash in on your investments in the short term and protect your principal, you will want to put their money in less risky and highly liquid investment vehicles.
Portfolio: What is the value of your portfolio? A $10 million dollar portfolio can withstand more risk than a $1 million dollar portfolio. The larger your portfolio grows, the percentage of loss should get smaller because you have more dollars invested and have the ability to allocate more dollars across different types of investments to diversify your holdings and mitigate risk.
Investor's Comfort: How much risk are you willing to take? Risk tolerance is an excellent example of "just because you can, doesn't mean you should." If you are young or have a large portfolio, you may not want to take on many risky investments if watching the market go up and down makes your stomach sour.
You have to be comfortable with your investments because investments are just that, investments in your future, and that take time to build. The value of your portfolio will also fluctuate. You do not want to take on more risk than you are comfortable with because you do not want to cash out prematurely because you saw one of your stocks drop in value.
On the flip side, you may be older or even retired and have enough investable assets that you may want to take more risks and swing for the fences on some investments. Each person and their portfolio is unique, and you want your investments to meet your objectives and be comfortable with your holdings.
People and goals change, so it is essential you keep your financial plan up to date to make sure you are heading in the right direction to reach your investment objectives.
Now that we have learned about some risk tolerance factors, let's discuss the three types of risk tolerance:
Aggressive: Aggressive risk investors are typically more experienced, in terms of investing, and have a higher net worth. Since their portfolios are substantial in value and broadly diversified, they are not afraid to take on bigger risks.
They have more capital in their portfolio which means they can spread their money across different types of investments and sectors of business. The more diversity, the more the investor’s portfolio's risk is mitigated because they are putting their eggs into many different baskets.
Aggressive risk investors can take big risks and get large returns, but they can also tolerate losing a significant amount of money. They are most likely to use riskier and more speculative equities, Exchange Traded Funds (ETFs), and other riskier investments because the returns are more significant because the risk is higher.
Moderate: Moderate investors are willing to take on some risk to their principal with their investments but are unwilling to take on significant losses. Their objective is to balance risky investments with safer investments. These investors may have intermediate time horizons (5-10 years) and may be looking at less speculative equities, mutual funds, and dividend-paying growth funds. Moderate investors earn less than aggressive investors, but they also lose less.
Conservative: Conservative investors are looking to take the least amount of risk and prioritize preserving capital over making gains. These investors tend to be retirees who are focused on minimizing volatility. Conservative investors do not want to lose their principal, and they usually target investment vehicles that are safer and highly liquid. Risk-averse investors tend to opt for money markets, bank certificates of deposits (CDs), or US Treasuries to provide income and preserve their capital.
Depending on your age, income, debt, and investment objectives, you may even be a combination of risk tolerance types such as moderate/aggressive.
If you aren't sure you are set up for success to meet your investment objectives or are concerned about your financial wellness in the short-term or long-term future, I am here to help you start a financial plan to get you on track to meeting your goals.