Many people assume that if they have a healthy appetite for risk in life in general, that their financial risk tolerance is the same. As a financial advisor in Brentwood, TN, we know better.
When it comes to financial matters, a person’s risk tolerance can be very different. You may enjoy rollercoasters, skydiving and other adrenaline sports, for example, but that might not equate to risking your life’s savings in an aggressive investment strategy. Sure, if successful, an aggressive approach may get you to where you want to be, and quickly, but an aggressive approach can also result in the opposite. Are you willing and able to take that chance?
The recipe for a successful investment portfolio has a number of important ingredients. You may feel you have just the right mix of stocks, bonds and cash. Your investments may align with your financial goals, whether it’s to generate income, grow for the future or preserve value. But if your investment strategy is too aggressive that you lose sleep at night or too passive that you don’t see the returns you need, your plan just may not work.
Financial risk, simply put, is the potential of loss from any investment decision. Any investment inherently carries some form of risk. Typically, the higher the risk, the greater the compensation (potential), paid in the form of investment returns. The lower the risk, the lower the return.
However, investment risk can take many forms. While many people equate financial risk tolerance to an aggressive stock market strategy, there can also be risk with a conservative approach.
For example, if you purchased a one-year bank CD paying 2 percent interest, and the inflation rate jumped to 3 percent that same year, you would actually take a 1 percent loss on your savings. This is a form of inflation risk.
Do a quick online search and you’ll likely find a handful of simple, 4- to 5-question risk tolerance tests that will ultimately label you as an aggressive, conservative or moderate risk-taker. However, determining your financial risk tolerance should involve an in-depth assessment that considers many factors.
Though your age isn’t the only thing to consider, typically speaking, as a financial advisor in Brentwood, TN, we tend to see older investors take a more conservative approach, as they are closer to the timeframe when they’ll have to live off their investments. If the market has a downturn, it can take a long time to recover – possibly years. However, a conservative approach may not be best, especially if you got a later start to your financial planning. Talk with a financial advisor about how your age affects your investment strategy.
Similar to your age, your time horizon also influences how much risk you may be comfortable taking. For example, if you are looking to purchase a new house in two years, you will likely need conservative, low-risk investments with a wealth preservation strategy. The average bear market lasts about 15 months, so taking on that much risk with such a small time window may not be worth the potential losses.
On the other hand, if you’re investing in a 529 Plan to pay for a child’s college education in 10 years or more, investing in a moderate or moderately aggressive portfolio could be worth it. You have the chance to grow substantially and, if the market declines, you’ll have time to make up any losses.
Now that you have a better understanding of risk tolerance, how do you apply it to your investing?
Though stocks and other investments seem to move in similar directions, this doesn’t have to be the case for your portfolio. The truth is, there are a number of different types of investment categories, called asset classes. And these asset classes don’t move in tandem.
DIY investors tend to rush into stocks when they are feeling confident about the economy, the market and their financial situations as a whole. This demand makes the markets rise. But when a recession hits, many of these same investors sell their stocks and jump into “safety investments” like bonds and bank products. Sometimes, the stock market and bond market move in opposite directions from one another.
Diversification is the process of balancing your portfolio with different asset classes, so when one ebbs, the other flows.
There are plenty of categories that you can hold to diversify your portfolio, as they all have varying levels of risk and returns each year. These additional categories include small cap and large cap stocks, corporate bonds, international stocks, government bonds, and more.
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High-net-worth investors often need additional help to potentially protect their portfolios or increase returns. If you are interested in investments that are slightly less traditional, alternative investments can be a great choice. The key is to work with a financial advisor who understands these types of investments. Adding them on your own can add more risk.
Read our recent blog post: Is Real Estate Right for Your Investment Portfolio?
There are many alternative investment options depending on your needs. Alternative investments include, but aren’t limited to, private equity, fine art, peer-to-peer lending, commodities and even collectibles.
Adding alternative investments can be a great way to generate new potential returns, without necessarily jumping into the ups and downs of stocks and bonds. What’s more, if you have a particular interest in an alternative investment, like certain collectibles, you can merge your investments with your lifestyle.
Including alternative investments in your discussions with your financial advisor can open up new, substantial opportunities for your finances.
Your risk tolerance is as unique as your fingerprint, and can change at any time. Whether you decide to dial up the risk level of your portfolio, keep things conservative, or begin investing in alternative investments, be sure to work closely with a financial advisor.
Neglecting to account for your risk tolerance can put your financial security and entire net worth unnecessarily in jeopardy.
Learn more about how TrustCore can help with investment management.
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