When it comes to investing, determining your risk level is the first step in planning your strategy. Stop and think. Do your endorphins start rushing when you’re teetering on the edge of danger or do you have heart palpitations? Are you comfortable taking big chances for the possibility of reaping large rewards, or are you more content to play it safe for more modest, but more reliable rewards? Your answers to these questions will give you a sense of your risk tolerance levels, but to determine your full risk profile, you’ll need to dig a little deeper.
Assessing your risk range is a calculated exercise that considers your time frame for meeting specific financial goals, investing experience and comfort level with worst-case scenarios. Even if you’re young and have a long-term horizon, you may not necessarily be comfortable investing aggressively.
There are other factors that can impact your tolerance of investment risk as well, such as your personal experiences and history, personality, current circumstances and future prospects. For example, maybe you are risk-averse because you got burned by a previous investment (or relationship) or saw your parents lose much of their nest egg in the last downturn. Or maybe you are an A-type entrepreneur and your whole life is about risk-taking.
If you want additional help figuring out your risk profile, there are plenty of free calculators available online with recommendations for the appropriate corresponding investment mix (or “asset allocation”). Charles Schwab offers a questionnaire in PDF format that you can save on your computer and print out. It also includes their asset allocation models, which interestingly illustrate that the difference in average annual returns between their most conservative and most aggressive portfolios is just 2 percent, but the worst-year return difference is over 31 percent! This goes to show that you can still get competitive returns with a “conservative” portfolio and that having an “aggressive” portfolio is sometimes not worth the risk (or anxiety).
Keep reading for more on how to invest for your risk profile.
The Right Mix of Risk
If hearing that the Dow lost 200 points one day causes you (or your partner) to want to sell all shares of stock immediately, you might be better off with a more moderate investment mix that includes less volatile, more predictable returns like bonds and bond funds. If you have a short-term investing window, you should have the majority of your money in fixed-income investments if you want minimal risk.
If you're adventurous by nature or already financially secure and have at least 10 years to meet your goals, then you may be comfortable allocating the majority of your assets to a diversified portfolio of stocks and stock funds that have the potential to provide the strongest returns over the long run, despite the likelihood of significant losses along the way.
Keep in mind that labels can be deceiving and being an “aggressive” or “conservative” investor doesn’t necessarily mean being one extreme or the other. A conservative portfolio can still lose value and an aggressive portfolio might not be as risky as you might think if it is well-diversified. You can also have a portfolio of mostly income-producing defensive stocks that could be labeled as “conservative” or a portfolio of high-yield and foreign bonds that could be considered aggressive. So don’t assume you are invested the way you want to be without understanding each individual investment you own and why.
If you are married or in a serious relationship and investing for a joint goal, you and your significant other should each determine your risk profiles. If they do not match, it may be in the best interest of your relationship to go with a more conservative asset allocation. Remember: most investors are more concerned about losing money than chasing the best returns. So, when in doubt, lean more conservative and consider dedicating at least half of your portfolio to less risky investments.
You might also like: