When you set up an investment portfolio, the most important thing to consider is your risk tolerance.
But what exactly do we mean by “risk”? Risk can mean a lot of things to different people.
You may assume that people who engage in risky activities like skydiving are naturally risk-tolerant, whereas those who have more temperate personalities or laid-back lifestyles are more risk-averse.
Interestingly, studies have found that risk-taking behavior in our personal lives has virtually nothing to do with our tolerance for risk in investing.
In investing, the risk in question comes down to this: How much can you tolerate watching your account value drop without reacting emotionally? Five percent? Ten? Twenty-five? Fifty?
When investment professionals talk about volatility, these drops are generally what they are talking about. True, volatility goes in both directions but, let’s face it: No one loses sleep about their account going UP by double digit percentages!
5 Tips for Assessing Your Risk Tolerance
Estimating your risk tolerance can help you identify what mix of investments is suitable for you.
In general, the higher your tolerance for downward fluctuations, the higher your allocation to stocks, usually in the form of stock mutual funds. Alternatively, the lower your tolerance for volatility, the more you should allocate to cash and short-term, investment-grade bonds, also known as fixed income in industry parlance.
Follow these five tips to determine your personal risk tolerance.
1. Consider How Much Risk You Can Actually Afford
Someone with a million dollars saved, no debt, excellent insurance and low spending habits can afford to take investment risk. Nonetheless, that same person may have an extremely low tolerance for doing so.
They would rather invest conservatively and live a modest lifestyle rather than watch the value of their account fluctuate wildly — even if they could have more money in the future for doing so. Such a person has a very high risk capacity, but low tolerance.
Conversely, someone with much less wealth may be willing to invest very aggressively. They might not bat an eye to watch their investment cut in half during a recession. Yet, due to a lack of savings, poor insurance or another oversight in their financial planning, they might have to liquidate some or all of their investments at a loss to cover the cost of an emergency or other unexpected expenditure.
Such a scenario is an example of someone who is very risk tolerant but has a much lower capacity for enduring a sizable drawdown in the value of their investments.
2. Your Age Is an Important Factor
Age is a key consideration in evaluating risk capacity, as well. In general, someone who is only a few years away from reaching their investment goal, such as retirement, is going to have a lower capacity for risk than someone whose investment objective is many years or even decades away.
However, consider that someone entering retirement in their early to mid-60s may still have an investment horizon of 20 to 30 years.
It is just as important to achieve a rate of return sufficient to avoid running out of funds in retirement as it is to avoid significant declines in the value of those investments. Here, the real risk is withdrawing too much from the portfolio in the early years of the planned investment horizon — especially if those early years coincide with a severe decline in the value of the portfolio.
Historically, advisers have recommended withdrawing no more than 4% of the initial value of your investment annually and adjusting that amount for inflation each year thereafter.
Keep in mind, however, that the 4% rule is based off of historical observations of the stock market, during which someone who followed the rule would not have run out of money in any 30-year period observed between 1926 and today.
With life expectancies increasing and interest rates remaining stubbornly low, a safer assumption might be 3% or lower — including what you pay in taxes.
3. Look at the Past to Evaluate Risk
Though past results are never a predictor of future performance, they are a great place to start when you’re evaluating risk. The simple rule is that if it’s happened before, it can happen again.
During the 2008-09 financial crisis, from the market’s peak on Oct. 9, 2007, to the bottom on March 9, 2009, the S&P 500 lost over 55% of its value.
The good news is that it rebounded by more than 76% over the following 12 months and by more than 400% exactly 10 years from the low point.
Regardless, if that kind of drop is too much for you to handle, you are likely to be better off investing in something more conservative.
4. If You Prefer Less Risk, Ask Yourself if You’re OK With Less Money
If you invest too conservatively, won’t you end up making less money 10 or 20 years down the road? In all likelihood, yes.
That’s why it’s imperative to look at your investments not just from the standpoint of risk versus return, but in terms of how likely you are to reach your goal. This is where having a financial plan comes into play.
Such a plan doesn’t have to be complex or expensive. There are a number of online tools that let you run basic calculations to guide you on how much you should save for a particular objective.
The advantage to investing more aggressively is that you should achieve a higher rate of return over time, which reduces the amount you have to save today.
That said, if you change course in the middle of an inevitable recession or other market correction, you are likely to lock in a lower rate of return than you would have had if you had simply employed a more conservative allocation.
For a conservative investor, it is worth the additional out-of-pocket costs to increase their savings in exchange for the added certainty that they will reach their goal, regardless of how the markets fluctuate.
5. Don’t Expect to Avoid Downturns
There is never a shortage of online pundits, bloggers and in-laws who will tell you how they avoided the most recent bear market by timing their way into and out of the market.
The next time that happens, ask to see a copy of their track record. It is surprising how quickly the free advice will dry up.
Researchers have demonstrated repeatedly that no one is able to successfully — and consistently — time their way into and out of the stock market to avoid periodic drawdowns.
In short, your brother in-law who says he successfully sidestepped the last market drawdown probably:
1. Can’t prove it.
2. Got lucky.
We humans have a remarkable tendency to recall our successes, while systematically discounting our failures.
It is a mathematical fact that for every person who successfully times the market this time, there is exactly one person on the opposite end of that trade who was unsuccessful. As a result, the likelihood of being on either the winning or losing side of a market timing strategy is about 50/50 — no better than flipping a coin.
Ultimately, in all but the most extraordinary cases, you would be better off maintaining your previously established asset allocation through the rough times and into the next recovery, rather than trying to time your way into and out of the stock market over time.
The whole point of investing in riskier asset classes, i.e., stocks, is to get higher returns than you would by keeping your money in a bank account or CDs.
History has shown time and time again that investing in riskier assets — eventually — leads to more money in your pocket than you’d get by keeping your money safely tucked away in a bank account or CD.
The key word here is eventually. The price for that higher return is your ability to withstand the inevitable bad times between now and when you hope to reach your investing goal.
If you cannot tolerate watching the value of your investments drop, sometimes significantly, during your investment period, you are likely to do more harm than good by changing course when the going gets tough and cashing out of your investments. In all likelihood, you would be better off never investing at all rather than cashing out after the value of your account has dropped.
Also keep in mind that these down periods can last for several years. Once you make the decision to invest your hard-earned savings, make sure you are committed (and capable) of sticking with it for the long haul.
David Metzger is a fee-only wealth manager in Chicago. He is a certified financial planner (CFP) and a chartered financial analyst (CFA). He has taught courses on personal financial planning and investing at DePaul University in Chicago and Christian Brothers University in Memphis, Tennessee.