The trade-off between risk and reward is a key part of any investment strategy. But risk means different things to different people. While risk is the key to unlocking greater gains, it can also be a source of sleepless nights and fingernails chewed to the quick. Each of us must find the right balance for our needs.
So how much risk are you willing to take on to reach your goals and sleep through the night? Figuring out your risk tolerance is a crucial step. It’s an important building block for your investment plan and can help you create a portfolio that’s well-positioned to meet your goals without compromising your financial—and emotional—health.
There’s no simple equation for determining your risk tolerance, but the following three questions can serve as a guide.
1. What Are Your Goals and Time Horizon?
Risk tolerance isn’t just an emotional attitude; it’s also logistical, determined in large part by your goals and time horizon.
Consider your own investment goals. In addition to long-term goals such as retirement, you may be socking money away for shorter-term goals such as your child’s college education or a down payment on a home. When do you want to achieve each goal? This is your time horizon.
The longer your time horizon for each goal, the more time you have to ride out short-term volatility in the market and the more risk you can take on. The market can experience dramatic swings in the short-term, which usually means taking on less risk for the assets earmarked for spending on your short-term goals. For instance, you might wish to ensure there are enough low-risk, liquid funds in your 17-year-old’s 529 plan to cover their college expenses over the next several years.
2. What Is Your Risk Capacity?
Your risk capacity is your practical ability to take on risk. It’s based on factors such as your savings, financial obligations, income level and job security. The more financially stable you are, the more capacity you may have to take on risk. However, if steep investment losses would hinder your ability to cover living expenses, pay down debt or meet shorter term goals, your risk capacity may be low.
Risk capacity can change over time in response to changes in your life. For instance, you might get a big raise or pay off big debts such as student loans or a mortgage. Either of those developments might make it easier for you to take on more risk. On the other hand, your risk capacity might decrease if you lose your job or take on new debt.
3. What Is Your Risk Composure?
We’ve touched on your financial capacity to take on risk, but what about your emotional capacity? Hardly anyone enjoys seeing their portfolio take a nosedive. But how good are you at managing those feelings? This is your risk composure.
You may get excited about the idea of taking on more risk in hopes of earning larger returns. Or, that idea may give you excessive heartburn. That’s an important difference, and one you need to consider if you don’t want your investment portfolio to be a constant source of anxiety.
However you feel about the idea of investment risk, you also need to consider how you will actually react to a market downturn. Will you be able to stick to your long-term investment plan, despite any misgivings you may have along the way? Or, during the inevitable market corrections, will you be too tempted to change course, selling slumping assets and potentially missing out on a rebound?
If you struggle to keep calm and carry on in a downturn, you’re not alone. There are several common behavioral biases that can hinder our ability to assess risk rationally. Learning to identify them can help you combat some of their counterproductive effects:
- Loss aversion: Losses tend to have a greater emotional impact than equivalent gains, so we try to avoid them—sometimes to our detriment. In investing, this can cause people to lose out on the potential for greater gains to avoid experiencing a relatively small loss.
- Recency bias: The media can be full of scary stories about what the market is doing at any given moment. Amid the onslaught of information, it’s no surprise that people get hung up on the latest piece of bad news, forgetting the powerful effects of the market over the long-term.
- Herd mentality: People tend to follow the crowd, assuming that if many people are doing something, it must be a good idea. For instance, herd mentality can lead investors to sell their assets when markets are down, hampering their ability to reach long-term investment goals.
Developing Your Risk Profile
Everybody has their own emotional relationship to money as well as individual goals, time horizon, and financial situation. Together, we can understand these factors and how they affect how much risk to take on in your portfolio. We can help you develop an investment strategy that hits the risk-return sweet spot, putting you in a position to realize your goals while protecting your fingernails.
