When it’s time to start crafting your financial plan, one of the first things we’ll ask is: What’s your tolerance for risk?
In the finance world, the word risk doesn’t have a negative connotation. In fact, risk can be a great thing. The key to designing a personalized, effective financial and investment plan hinges on your personal tolerance for financial risk.
In simplest terms, risk tolerance is the measure of your ability to withstand loss. Your level of risk tolerance has everything to do with whether you are comfortable with losing some or all of the money that you invest.
You might be thinking, “Why on earth would anyone be comfortable losing money?” Consider the old saying: you have to spend money to make money. The same principle is at work here. In order for your investments to grow, you must be comfortable with the fact that there will be downturns in the market. The upside is that the longer you can keep your money invested, the more you will gain when the market grows strong again.
How do you determine your risk tolerance?
We start by asking questions like these:
What is the maximum risk you’re willing to take regarding your investments?
Are you investing for retirement, or for more short-term goals?
Do you have other assets that we should consider, such as a pension or social security that will make up part of your retirement or financial portfolio?
Three levels of risk tolerance
Every investor falls into one of three broad categories of risk tolerance.
Aggressive
Generally, younger investors or those who have a lot of time on their side before they will need the money can afford to be aggressive. If you have a decade or more until retirement, and/or have a lot of money in the bank and can afford to lose money short term to benefit long term, you can afford to be an aggressive investor.
Moderate
If you prefer a more balanced approach to investing, can take on some risk, or are interested in combining a mix of riskier investments like large company mutual funds with safer options like bonds, you are likely a moderate investor. Your goal is to achieve balance. While you may sacrifice some long-term growth of your money, you’re okay with that to have some comfort.
Conservative
You want to accept little to no volatility of your money. Perhaps you are close to retirement and can’t risk losing your nest egg so close to when you’ll need it. Maybe you just want options that are a little better than a savings account. If so, certificates of deposit (CDs), or U.S. Treasury bonds are examples of investments that may work for you.
Your personal level of risk tolerance will probably change over time. You may start as aggressive but transition to moderate or conservative as years pass or your goals change. Or, you may want to start investing conservatively and then take on greater risk once you’re a little more comfortable with investing.
How to manage risk
Once you have determined your level of risk, it’s time to decide how to manage it.
The key with any financial plan is diversification. Ensuring a mix of investments over time allows you weather varying levels of risk.
Remember that some loss is necessary for your money to grow over time. If you want true stability, keep your money in a savings account. Think about rose bushes as an analogy. In order for a rose bush to flourish over time, it needs to be heavily cut back once a year. Sometimes, those cuts can be drastic and appear shocking. But an experienced gardener knows that without that high level of pruning, the bushes may not die, but they won’t grow to their fullest, either.
Our strategies for managing risk stem from the concept of balance. We will work with you to balance and rebalance your portfolio so you always have the right proportion of high, medium, and low risk investments to achieve your financial goals.
It’s all about perspective
Investing is much more of a qualitative action, as opposed to quantitative. That means that your risk tolerance is about understanding and accepting a measure of fluctuation, not about earning a specific dollar amount on a specific date.
Perspective is key. When the market drops, and it will, you can panic and mourn the loss of what you had the day before, or you can rest easy in the knowledge that a drop in the market is simply an opportunity to buy more shares cheaply, and grow your money moving forward.