Figuring out how much risk to take in a portfolio can seem like a simple calculation, but for most people, emotions tend to make the process more challenging. On the surface, we all know risk is a necessary component of investing, but finding the right amount of risk to achieve our goals is more complicated than just picking a number between one and ten.
There are many factors that determine how risky an investment is. Broadly speaking, stocks have different risks than bonds. Specifically, annual revenue, geographical location and the size of a company are just a few factors that are considered when determining the amount of risk in a stock. For bonds, some factors include duration, financial health of a company and current interest rates. Properly analyzing and assessing each of these risks is best done by a professional who knows what to look for. Once you have an accurate measurement of risk for each type of investment, you must then figure out the right mix for your portfolio.
A commonly referred-to phrase in wealth management is “risk tolerance.” In other words, how much risk can you tolerate in your portfolio and still sleep soundly at night? Oftentimes, risk tolerance is determined by filling out a questionnaire or answering a survey. The questionnaire or survey attempt to calculate an individual’s risk tolerance using math and a simple ranking scale. These methods lack purpose and people end up not sticking with the risk in their portfolio during a down market cycle.
It’s more effective to decide how much risk to take by matching it to a particular goal. Working with a professional to create a financial plan ensures that a specific time frame is defined so risk can be applied to a future goal. The further the goal is in the future, the more risk you can take. The sooner the goal, the less risk you should take. Planning for retirement 30 years from now requires taking a different amount of risk than planning to buy a home in five years. When you’re able to keep your eye on the prize, constructing a portfolio with the appropriate amount of risk and sticking with it becomes much more tolerable. It’s also important to point out that the risk you “should” take may be different than the risk you can tolerate. Figuring out how much risk to take ends up being a balance of emotions and pragmatism. This balance can be difficult to achieve, which is why working with an advisor is so important for many people.
One final note on risk. In my experience, people tend to have a preconceived notion about their own risk tolerance, but in reality, their portfolio is nowhere near that stated risk profile. I have often met with people who tell me they are very conservative and risk averse, but when I analyze their portfolio I find they’re very aggressively allocated toward mostly stocks. This disconnect typically happens when someone has implemented the set-it-and-forget-it method of investing. They may have put time and effort into allocating their portfolio years ago, but they paid little to no attention since that time. Goal-based planning works only if the goal, and the amount of risk taken, is continually evaluated over time.
Risk can be a blind spot in your portfolio in a number of ways. You may be taking too much or too little risk, depending on your goals. Not understanding how risk is determined may be keeping you up at night. It’s our job to educate our clients on how risk works and collaborate on creating achievable goals using risk appropriately. If you’d like to discuss how much risk you should be taking in your portfolio, please feel free to reach out to us and we’d be happy to discuss.
