Risk Tolerance-Making Sure Your Investments Don’t Keep You Up at Night

One of the first things you have to do when you start investing is to gauge your risk tolerance, so that you make sure that the your investments are appropriate to your personal situation. The components of your risk tolerance generally include:

  • Time horizon: When do you need that money? If you need it sooner, you should take less risk.
  • Portfolio size: Larger, more diverse portfolios can absorb and recover from losses more easily than small holdings.
  • Financial position: You can take more risk if you have higher income and less debt than if you have lower income and less debt. Income stability is also a factor, so those with incomes that fluctuate more should take less risk.
  • Personal Risk Tolerance: How much does losing money bother you? Are you willing to lose some money if it means you can make more?

You can have different risk profiles for different types of investments or at different times of life. For instance, you should be more risk-averse with a high school student’s 529 plan than you would be with a preschooler’s, because you will use it much sooner.

I’ve read a lot about how Millennials are more risk averse than you would expect for younger investors, in part because they came of age during the great recession. They are reluctant to put their hard-earned money into the stock market or even buying a house because they saw how much these things were devalued in the late 2000s. Low levels of income stability and high student debt are also contributing to more conservative investment behavior. However, by not putting some money at risk with their investments, Millennials may lose out on long term wealth building opportunities. Greater risks mean more possibilities of loss, but also possibilities of greater rewards. And being too safe with your money has costs as well.

The US economy hasn’t hit 2 consecutive years of annual inflation rates above 4% since 1988-1991, and hasn’t seen a 10% or greater annual rate since 1981. Millennials haven’t yet seen how inflation can wipe out the purchasing power of savings. Last year’s annual rate of inflation (1.6%), while low, is higher than the interest rate paid for most savings accounts, money market accounts and CDs. Holding funds in cash, in most cases, is costing you purchasing power. While a cash reserve is necessary, it shouldn’t be where you are holding all of your assets.

The first three factors are objective. You should have a pretty good idea of what your income and expenses are. It’s also a good idea to put together a personal balance sheet as well. A lot of banks have you do this for loans, but it’s a good idea to keep one for your personal reference. Just list all of your assets and their approximate values (bank balances, investments, real estate, present value of vehicles, and personal items) and total them. Then list all of your liabilities (mortgages, car and student loans, credit card balances, etc) and total them as well. What’s left is your personal equity. Doing this will give you an idea of how much capacity you have to take on risk, among many other benefits. Figuring out your personal risk tolerance is a little more nebulous.

There’s a quiz over at the Rutgers University website that tries to determine your personal risk tolerance by asking you about hypothetical investments and losses. I was not surprised to find that I had an above-average tolerance for investment risk. I’m pretty comfortable with moderately risky investing behavior, like investing in individual stocks and international mutual funds, but I mitigate risk by holding bonds and cash as well. The stocks I own tend to be large, well-known companies with solid fundamentals. I tend to see market downturns as buying opportunities rather than catastrophes, because I am still many years from retirement. I know that as I get older, my strategy may have to change, but I also know continuing to invest after I retire can help protect me against rising prices.

Not everyone feels the way I do though. Some people are far more comfortable taking risk than I am. They may be all in to the stock market with active trades (I’m more of a buy and hold girl myself), and involved with commodities and derivatives (nope, no futures or options for me, thanks). They may keep almost everything in the market, and only see the possibilities their investment can bring. Others lose sleep over what every market dip does to their 401K balance, even though almost all of their investments are in cash and bonds. They understand that it may take years to recover from a downturn, if they do at all, and emphasize conserving capital above all else.

Everyone needs to be able to sleep at night. The best strategy for mitigating an extreme position on either end of the investment risk spectrum is diversifying your investments. If you are risk averse, keeping most money in cash and bonds is the right move for you, but you should consider some index funds or mutual funds as well so that you allow a rising market to counteract inflation. Real estate investments, like rental properties and REITs, may also be attractive investments to increase returns by adding alternate income streams to your portfolio.

If you are really comfortable with your risk taking, keep some cash for stock downturns, if for no other reason than to buy low.  More importantly, remember that just because you are comfortable taking risks doesn’t mean that it is the best behavior for your situation. Diversification allows you to take some big risks with part of the portfolio, while preserving capital elsewhere to absorb setbacks.

Another way to make sure that your investment strategy works regardless of your risk tolerance is to educate yourself on investing in general (hey! You’re working on it if you’re here!) and on the specific investments you are choosing. There is plenty of information available on types of investments and their risks, costs, and potential rewards. There is plenty of information on most publically held companies, through their investor services web page, websites like Yahoo Finance and Morningstar, and the SEC filings database.

Finally, make sure that you are reassessing your investment strategy with life changes. Rebalance your portfolio periodically to make sure that your investments are appropriate for your situation. You need to have the capacity to absorb the investment losses to which you expose yourself, either through income, your time horizon or your other assets. The best mix of investments today may not be the same as it was 5 years ago, or that it will be in 5 years.

This article is for information purposes only. Past performance does not determine future performance, and an investor interested in any company’s stock should proceed with caution and do lots of research before putting their money in any investment.

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

References and Further Reading

3 Ways for Millennials to Overcome Their Fear of Investing-from MoneyNing.com

Determining Risk And The Risk Pyramid, Risk Tolerance Only Tells Half The Story and Investing For Safety and Income Tutorial-from Investopedia

How Inflation Can Eat Up Your Savings — and How to Avoid It-from Fool.com

Quiz: What’s Your Risk Tolerance?-from LearnVest

Risk Tolerance and How It Affects Your Investment Strategy-from Moolanomy

What’s Your Risk Tolerance?-from US News & World Report

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