You make unconscious assessments of risk every day and even build your routines around them. On a typical morning, you may judge that the reward of sleeping in is not work the risk of losing your job for tardiness. On the other hand, you may judge that driving to work is worth the risk compared to the alternative of a long walk.
When it comes to your investments, you need to make a conscious decision of how much risk you are willing to accept. Your willingness to accept the risk of investment losses is called your risk tolerance and it is one of the most important factors in creating a successful investment plan.
What is risk tolerance and why is it important?
All investments have some level of risk – even if it is miniscule. Generally, those with a higher risk of losses will have a higher potential for gains. Your risk tolerance is a measure of your willingness to accept the risk of losing money in exchange for the possibility of returns.
Risk tolerance is a spectrum that ranges from aggressive to conservative. Investors with an aggressive risk tolerance are willing to accept a high degree of uncertainty in exchange for the possibility of high gains. Those with a moderate risk tolerance are willing to accept some risk but also want to protect their assets. Finally, investors with a conservative risk tolerance place preservation of their funds at the forefront and are generally willing to accept little to no risk of losses.
The amount of risk you are willing to take establishes the types of investments that are well suited to your portfolio. In turn, these investments determine your ability to meet financial goals, and your overall comfort with your financial situation.
Determining Your Risk Tolerance
Risk tolerance is a personal decision that can vary depending on your goals, time horizon, and emotional response to a changing account balance. To determine your risk tolerance, you should carefully consider these factors as they relate to each goal for which you are saving.
To get a head start on determining your risk tolerance, complete the risk assessment below. Then, read on for an overview of the factors you should consider.
Consider Your Saving Goal and Progress Toward That Goal
The goal of your investing account is an important consideration when determining how much risk you should take. Some of the most common financial goals are saving for a successful retirement, investing to fund a child’s education, setting money aside for a large purchase like a home, and creating a nest egg to pass to your heirs. Each of these financial goals may require a different investment approach and a different tolerance for risk.
Your progress toward your goal is also an important consideration since it determines how much your investments need to earn to push you over the finish line. If you are very near your target, you may be able to take less risk with your investments. On the other hand, if you have a long way to go before you reach your goal, you may need to invest more aggressively to reach it.
Consider Your Time Horizon
You will also need to consider the amount of time you have to invest before needing the money from your account. If you have a short time horizon or need income from your investments today, you may have a lower tolerance for risk. Conversely, if you have many years until you need to withdraw from your account, you may be able to accept more risk along the way.
For example, assume that you are saving for your child’s college education. If you are making investment decisions shortly after your child is born, you may be willing to accept more volatility in your portfolio since you have eighteen years before you need to access the funds. On the other hand, if you are making decisions when your child is already submitting applications to schools, you may be unwilling to accept large swings in the portfolio value since you will soon need the money.
Consider Your Emotional Wellbeing
The final consideration to determine your risk tolerance is your emotional response to a changing portfolio value. Ask yourself how you would feel if you woke up one day and your portfolio had lost 20%. If you are not concerned with this loss and see lower prices as an investment opportunity, your risk tolerance might be considered aggressive. Conversely, if you believe you would experience severe emotional distress from this loss, you probably have a lower, more conservative, tolerance for risk.
Incorporating Risk Tolerance into Your Financial Plan
Once you understand your risk tolerance, you can use this information to create or update your portfolio. In most cases, your risk tolerance impacts the entire makeup of your portfolio including the types of investments that you choose and the amount of each that you own.
If you have an aggressive risk tolerance, you may be able to incorporate risky assets that most other investors shy away from – like high-Beta stocks, high-yield bonds, commodities, and cryptocurrencies. On the other end of the spectrum, if you have an extremely conservative risk tolerance, you may prefer low-risk assets like short-term bonds, money market funds, and Certificates of Deposit. There are also many types of investments with a moderate amount of risk like low-Beta stocks, high quality bonds, and broad market ETFs.
Fortunately, you don’t have to choose just one type of investment. You can create a portfolio that incorporates many types of investments that tend to have opposite reactions to market events – also known as diversifying your assets. Through diversification, you can reduce overall portfolio risk and strike a balance between risk and reward.
If you need help building a portfolio that incorporates your risk preferences, enlist the help of an experienced wealth manager. They will guide you through the process of determining your risk tolerance, then handle investment selection on your behalf. The result is a diversified portfolio consisting of investments that match your tolerance for risk and are intended to help achieve your financial goals.
Get A Custom Portfolio That Matches Your Risk Tolerance with Investing Gameplan™
At DreamWork Financial Group, we help investors understand their risk tolerance and invest accordingly with our innovative wealth management program, Investing Gameplan™. This program includes a comprehensive analysis of your investing goals and tolerance for risk which is overseen by a fiduciary financial advisor.
Once your advisor understands your tolerance for risk, they will help you chart a course to achieving your financial goals with a completely custom portfolio. Most investors think this level of personalization is only for the very wealthy, but at DreamWork, You Don’t Have To Be Wealthy To Have Wealth Management®.
Contact us today to learn more about Investing Gameplan™ and get started with your custom portfolio.