This seems like a good time to talk about risk. Today risk is present in everything we do - from deciding to wear a mask, to going to the grocery store, to visiting with friends, to flying on a plane. Doing ordinary activities that we barely gave a second thought to six months ago are now important decisions to be made. Is the risk worth it?
In the investment world we talk about risk...a lot. It is a key investment concept.
In the investment world we talk about risk...a lot. It is a key investment concept. Webster’s online dictionary defines it as a hazard; danger; peril; exposure to loss, injury, or destruction. Sounds scary and important! It is both - and in this article we will explain why, as well as how to understand your risk tolerance level to optimize your return potential.
Most people know that investing in stock and bond markets can be risky. Markets move up and down on any given day for seemingly any given reason. Investing your hard-earned savings can be particularly hazardous if one does not understand markets, asset classes, or how to define and quantify the risk inherent in each.
It is also important to understand your own risk tolerance. How much volatility can you comfortably tolerate? There are two sides to one’s risk tolerance. There is the emotional tolerance that is normally developed (or not) over time as one gains investment experience through bull(up) and bear(down) markets. Then there is the situational tolerance for risk; this factors in all the demographics such as age, income level, years to retirement, etc. An investment advisor will assess these questions regularly to ensure the level of risk in one’s portfolio is appropriate for them. Investing is not a ‘one size fits most’ endeavor.
Why Knowing Your Risk Tolerance is Important
Investment advisors build portfolios starting with an asset allocation. The asset allocation is an investment strategy that aims to balance risk and reward by proportioning a portfolio's assets to different segments of the markets. How it is distributed should be appropriate to an individual's goals, risk tolerance, and investment horizon.
An investment advisor makes her asset allocation selections based on the information she collects from the client (risk tolerance, goals, time horizon) along with many years of experience and knowledge of markets, asset classes, correlations, diversification, inflation, and interest rates, among other things. The risk tolerance conversation will illuminate whether you are able to tolerate a negative 10%, 20% or 30% fluctuation in your investments. There is no right answer; rather it points to the mix of assets the investment advisor will select.
Most of us look at our monthly statements and note whether our balances went up or down. The degree to which they go up or down is determined by the risk/reward “balance” of the asset allocation as well as the market performance of individual asset classes.
Finding the balance between the client’s unique situation and objectives with the dynamics of the markets is the ultimate objective.
How Do I Reduce or Manage my Risk
There are several steps a client can take to effectively manage their risk and improve their results. For those who are self-directed:
If you prefer to engage a professional we recommend these steps: