Traders work on the floor of the New York Stock Exchange (NYSE) in New York.
Brendan McDermid | Reuters
Building your investment portfolio is dependent on your ability and willingness to take on risk. The more you’re willing to take, the higher your potential returns … and losses. Your risk tolerance depends on your risk capacity and your risk willingness, and is affected by age, stage in life, and goals.
If you’re investing for retirement and are 45 years old, you have more time to grow your money and can take on more risk than a 65-year-old can. With 30 years to build a nest egg, your investments have more time to ride out short-term fluctuations with the hope of receiving a greater long-term return.
Here are five tips to help determine if you’re risk-averse, a risk-seeker, or somewhere in between.
1. Determine your risk profile
Important factors include your time horizon (length of time of your investment) and your risk tolerance. These help you get an idea of which investment strategy, from conservative to growth-oriented, corresponds with your investor profile.
When you’re afraid of taking on risk that could cause a decline in your portfolio’s value, you’re risk-averse and more conservative. When you want larger gains and are willing to take on more risk, you’re a risk-seeker, leaning toward growth. Most people are in the middle.
If you have a lot of liabilities (debt) and little cash assets, you’ll tend to be risk-averse because you can’t afford to take on risk. If you have large cash assets and few liabilities, you’re better positioned to take on risk.
2. Understand your risk tolerance
Modern financial planning utilizes two independent risk scores: risk capacity and risk willingness. Risk capacity is based on your investment objectives, initial investment amount, and time horizon. This addresses your ability to handle risk and the primary investment goal.
Risk willingness indicates how willing you are to accept investment risk in terms of volatility of investment returns as well as the probability of loss.
How comfortable are you with risk? Are you more concerned about your investment losing value, equally concerned with your investment losing or gaining value, or more concerned with your investment gaining value?
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It’s vital to understand that some investments may have dramatic fluctuations in value with high potential for larger gains, while others may be more stable with less returns. Choose investments that fit your risk tolerance level.
3. Know your time horizon
Your timeline for meeting your goals is vital. How long until you withdraw money from your investments? Once you begin, how soon do you plan to spend all of the funds?
4. Select your investment strategy
As you determine your risk profile and evaluate investments, you might allocate money into various categories (or work with an investment professional). Typically, investing dollars are allocated among a spectrum of portfolios: conservative, conservative balanced, balanced, balanced with growth, and growth equity.
5. Determine the kind of risk you’re comfortable taking
Figure out what risks exist, which ones you’re willing to take, and which ones aren’t worth taking. In addition to volatility risk – risk related to the stock market – you should be aware of:
- Market risk: A general decline in financial markets causing investment losses.
- Inflation risk: Rising prices limit your ability to purchase goods and services with your investment dollars.
- Interest rate risk: Increases or decreases in rates and resulting price fluctuation of an investment, particularly bonds.
- Reinvestment rate risk: Reinvesting funds at a lower rate of return than your original investment.
- Default risk: When a bond issuer can’t pay bondholders’ interest or repay principal.
- Liquidity risk: How quickly investments can be converted to cash.
- Political risk: The adverse effect of new legislation or changes in foreign governments to overseas markets or companies you invest in.
- Currency risk: Fluctuating rates of exchange between U.S. and foreign currencies negatively affecting the value of your foreign investment, as measured in U.S. dollars.
It helps to understand the kinds of risk and the extent of risk that you choose to take, and then to learn ways to manage those risks.
However, while this do-it-yourself approach is a good start, risk profiles don’t replace your existing financial strategy. Your financial advisor can connect the emotional dots of your risk analysis as part of their process to help map you to the portfolio that fits you best. It’s important to go through this exercise on an ongoing basis because your financial goals and your tolerance for risk will change over time.
—By Kevin Simpson, founder and chief investment officer at Capital Wealth Planning, and author of “Walk Toward Wealth.”