The Disciplined Investor
What Does it Take to Take on Risk?
With recent market volatility, you may be looking at your portfolio returns and wondering if you should make investment changes to decrease risk. 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 can be a source of sleepless nights, it can also be the key to unlocking greater gains. 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.
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 funding a long retirement, you may be socking money away for shorter-term goals such as your child’s college education or a lake cabin. 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.
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 streams 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 inheritance or pay off big debts such as student loans or a mortgage. These 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.
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 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. This means that the joy of gaining $10,000 is less emotionally impactful than losing $10,000. This tendency can lead people to “sell to cash” when the market is down to avoid further pain and may also lead people to favor investment mixes that are too conservative.
- Recency bias: Recency bias is the tendency to overweight the importance of recent experience or the latest information when predicting what will happen in the future. Following a couple years of strong of market returns, our tendency is to overweight the likelihood that the market will continue to go up. On the other hand, when the market is going down and the media is full of scary stories, we may be inclined to overweight the probability that the market with continue its decline. Focusing on a long-term, evidence-based strategy rather than short-term market noise can help overcome recency bias.
- Herd mentality: People tend to follow the crowd, assuming that if many people are doing something, it must be a good idea. Herd mentality can lead investors to sell their assets when markets are down, hampering their ability to reach long-term investment goals. In another example, herd mentality can lead to speculative bubbles, where investors rush into popular assets at inflated prices, or panic-driven selloffs when markets decline. Following the herd may feel safe in the moment, but it can result in buying high and selling low—one of the biggest mistakes an investor can make. Wise investing isn’t about following the crowd—it’s about following a well-designed financial plan.
Developing Your Risk Profile
We all have our own emotional relationship to money, individual goals, time horizons and financial situations. Evaluate these factors and their influence on how much risk to take on in your portfolio. Your financial advisor can help you develop an investment strategy that hits the risk-return sweet spot, putting you in a position to help you realize your financial goals.
Hello! I’m Saul, a wealth advisor and financial planning specialist at Allodium Investment Consultants, located in Minneapolis, MN. I am dedicated to helping our clients reach their financial goals by specializing in investment strategies and comprehensive financial planning. When I am not advising clients, you will find me spending time with my wife, Khara, and daughter, Brielle. We live on a hobby farm, which supports my love of gardening and cooking. I have also been a downhill ski racing coach and enjoy outdoor activities, including canoeing, camping and photography.
The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.