How to Gauge Your Risk Tolerance for Investing

I can recall the day vividly. 

“This is like the other ones I’ve been on, right?” I asked my dad.  

“Sure,” he replied, “You’ll love it!”  

I sat next to my father, a hesitant smile on my face, as the man fastened the safety bar over our laps. Our string of carts ascended a long hill, paused for a moment, then plunged into a special type of hell that involved plummeting, skyrocketing intermittently and being jerked around sharp corners in between. Busch Gardens called it “The Big Bad Wolf.” I called it the worst experience of my life at a theme park. My brother called it “rad” and happily ran back in line for a second round while I clung to my mother’s side.  

Ah, roller coasters. Some people love ‘em, others not so much. The moral of this story as it applies to investing is: Before you jump in, know your tolerance for ups and downs and what type of ride you’re signing up for.

Each day, I have discussions with clients, friends and even strangers about the market. The ebbs and flows of the stock market are fun to comment on and can be alluring to investors wanting to make their money grow. If you want to know a secret to investing success, I can summarize it in one word: Risk.

See, it’s not so much about loading up on today’s hot stock then off-loading it at the right time. The key to investing success is in managing your risk. 

Here are four questions to ask yourself (and your financial planner) to get you on the right track to success:

1.  What is my risk tolerance?

It’s easy to be aggressive in an up-market year. After 2013’s exciting return of over 30 percent for the S&P 500, many investors are eager to be on the stock band wagon. However, it’s important to know how you’d feel if we had a market correction of over 10 percent in the next year or so. Would you still like to be all in, or would you lose your lunch reading your investment statement? 

Another way to think about it is this: If you have a $100,000 portfolio that loses 20 percent in one year, then you’re down to $80,000. In order to get back up to $100,000, you’d have to earn $20,000, or 25 percent, in the following year to come back to your starting point. If you only lost 10 percent in one year, down to $90,000, then you’d only have to earn $10,000, or 11 percent the next year to come back to your starting point.   

The amount of risk you take on can make it more difficult for your portfolio to climb back from a plunge. If you’re OK staying in the market and can endure a longer comeback, it may be worth it to get into a more aggressive strategy. 

Your time horizon can also help you determine how much risk you should have in your portfolio.  Your time horizon is how long you have to invest your portfolio until you need to liquidate it. For example, if you have money to invest but want to take it out to buy a house in five years, your time horizon is different than if you’ve got an IRA to invest, but aren’t going to take distributions out for another 25 years. The longer the time horizon, the more time you have to bounce back from a market decline. 

2.  What risks are in my investment portfolio?
There are all kinds of risk out there. There is no way to have risk-free investments, despite what infomercials might promise you. If you’re investing, there’s always some risk involved (I know, I sound like Debbie Downer, but it’s the truth!). Here are a few risk-related terms to get familiar with:

  • Standard Deviation — This is the volatility of your portfolio. It’s the range of returns about two-thirds of the time. Generally, if your portfolio has a standard deviation of 10 percent, and an average return of 5 percent, then two-thirds of the time, your returns will be between -5 percent and +5 percent. 
  • Beta — This tells you how your portfolio will move in comparison with the market. The higher the beta, the more your portfolio will move along with the market. For example, if you have a beta of .70 compared with the market, then you’d generally expect it to be about 30 percent less volatile than the market (it would go up about 70 percent of the market and down about 70 percent of the market). A beta of 1.3 would mean you’d expect it to be about 30 percent more volatile than the market.
  • Sharpe Ratio — This is the risk-adjusted return of your portfolio. Ideally you want the Sharpe ratio of your portfolio to be higher than your benchmark (the index that you compare your portfolio to).  Even if one fund or manager has a higher return than another, Manager A can add higher risk assets to produce a higher return than Manager B, but Manager B may have a higher Sharpe ratio, meaning that Manager B has a better risk-adjusted return.
  • Credit Risk — Think of two friends you may have — one is a total party girl who crashes on couches and never has enough cash to pay her own way, and the other is a successful, stable lady who has been saving her money and investing it wisely since you were little kids. They both want to borrow money from you, with interest. Which one would you want to loan the money to? Probably not the couch crasher, and if you did loan it to her, you’d probably charge a high interest rate because you’d be afraid you’d never see the cash again. 

Apply this to bonds, and you can see the difference between, say, a AAA grade corporate bond and a high yield or junk bond. Really strong companies like Apple don’t have to pay bondholders high interest rates because, well, you know they’re gonna pay it back. Smaller companies or companies that have some risk of possible default usually pay a higher interest rate. This doesn’t mean you shouldn’t have higher yielding bonds; just know that there is some risk in owning these bonds. Weigh it out: Are you being properly rewarded for the risk you’re taking on?

Interest Rate Risk —  When interest rates go up, bond prices go down. Bonds are funny animals: their prices and rates move inverse to each other. What I mean by this is that if a $100 bond is paying you 5 percent per year, or $5 per year, and rates jump up and you can get a bond that pays 10 percent, or $10 per year, if you try to sell your 5 percent bond, no one will want it. So you’d have to sell it at a discount, probably until it was paying out 10 percent too. The price would have to fall to $50 in order for that to happen, so as the yield goes up from 5 percent to 10 percent, the price has to go down. When rates go up, then most of the existing bonds will be pretty unattractive, so you would have some interest rate risk on anything that has rate sensitivity. This includes bonds, preferred stocks, higher dividend paying stocks and real estate investment trusts.

3.  What strategies can I use to mitigate risk?

  • Put your eggs in different baskets. One of the best ways to combat risk is to have a solid asset allocation. This means diversifying your portfolio among different asset classes, which includes U.S. domestic companies, fixed income investments (like bonds) and other areas like real estate investment trusts, master limited partnerships and even good old cash. During super exciting years in the stock market, you probably won’t see returns as sexy as the S&P 500 can give you. But during the down years, you likely won’t see the lows you’d experience if you were 100 percent invested in stocks.
  • Neutralize your holdings. Some managers use other techniques, like trying to become market neutral by buying a stock that they believe will go up and buying a short position against stocks they think will go down (short means betting against). This can be done via a pair trade — you buy one stock you think will do well in a particular area (like Coke) and short a position in the same area that you don’t think will do well (like Pepsi).  
  • Cover your assets. Other managers write covered calls as a way to diversify their strategies. You are essentially selling another investor a right to buy your stock at a certain price. For example, you think that Nordstrom is going up, and it’s currently priced at $68/share. You sell a call for $72, meaning that you’ve sold another person the right to buy Nordstrom from you for $72/share for a period of time. If Nordstrom goes up to $75, then you’ve potentially lost out on another $3 in profit. If Nordstrom goes up to $71 and doesn’t budge for the entire time period, you would still have Nordstrom, plus the money the other investor paid you for the contract.
  • Exploit new relationships. If two companies are engaging in a merger, some managers will purchase the company being acquired and sell or short the stock of the company making the purchase. 

4.  How will I execute these strategies?

The above concepts are sophisticated investment techniques that require research and expertise. I don’t recommend them as a technique for investors who are new to the area of personal finance. However, these techniques can be great ways to add diversity and reduce the risk of portfolios when done with a professional advisor.

If you’re new to investing, or are still working on building your portfolio, start with a basic asset allocation strategy to get a good balance of equities and fixed income that reflect your risk tolerance. As your knowledge and portfolio grow, you can incorporate additional techniques and asset classes to build on the foundation you created at the beginning. 

Check in on your portfolio regularly, but know that timing the market doesn’t always work. You often see people on TV talking about how they “called” the market correction, or knew the market would go up a certain amount. However, most of these people don’t have a proven history of an ability to regularly make these calls. Employing a solid, long-term plan for your investments is going to beat out a one trick pony’s prognostications, so try to stay the course.  As with most things in life, reducing the drama in your financial life opens you up to more enjoyable things, like dreaming up more goals for your future!

Emily Boothroyd is a member of the DailyWorth Connect program. Read more about the program here.

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