In my last post on asset allocation I talked about some basics of what do to with your money based on some time frames in which you thought you would need to use the money. I also gave a general rule of thumb for splitting your portfolio between stocks and fixed income. In this post we’ll take things a step further and discuss how to determine your personal tolerance for risk.
One of the most important keys to being a successful investor is to understand your risk tolerance. Which loosely defined means how much variance you’re willing to take on in the short-term for greater gains in the long run. The reason this is so key is because it lets you invest at a level in your comfort zone which makes it easier to stick to your master plan even when the markets turn south. Taking on more risk than you can handle may cause you to panic when the market heads south and sell off your investments thus locking in those losses and causing irreparable damage to your finances. For example: Anyone who bailed out of the stock market and into cash during the markets darkest days in 2008 missed out on the incredible gains and recovery from 2009 to the present.
The largest factor in risk tolerance is usually age. Younger people can usually afford to take more risks simply because they have more time to recover from any losses they suffer. Whereas people closer to retirement simply don’t have the time to wait if they suffer a huge loss in portfolio value.
To determine your risk tolerance you must first:
- Determine your Financial Goals
Is your main concern saving for retirement? Saving for a new car? A down payment on a home? Whatever your goal is, and time frame for that goal will determine how much risk you can take (as discussed in part 1). If you’re just starting out and just think you need somewhere between 1 and 5 million dollars to be able to retire in the next 30-40 years that’s ok. It’s a starting point and you can adjust as you go.
- Assess your Current Financial Situation
You can’t get to where you’re going without first knowing where you are. If your goal is to retire with $1 million in 20 years and you’ve already saved $700,000 in your portfolio your need for risk is going to be almost non-existent compared to someone with the same goal but only $50,000 saved. Also check on your debt situation. I’ve mentioned before the importance of paying off your high interest debt before focusing on investing.
- Determine your Risk Comfort Level
This is the big one. This is where you determine how aggressive your portfolio will be. It’s easy to say you can handle the swings the market will throw at you until they actually happen and you’re staring at a significantly smaller number next to “Account Balance”. Only you can determine how much risk you can handle. I can only say that risk shouldn’t necessarily be viewed as a bad thing. The volatility that results in some of those large downward movements also results in the large upward movements we’re ultimately in this game for. There may be painful short-term losses, but over time the markets always turn positive. A useful tool I’ve found for helping determine your comfort level with risk is this survey that was developed by two finance professors. Go ahead, take it, and use the results as a starting point for your risk tolerance. (Risk Tolerance Survey) I scored a 34 which means I have a high tolerance for risk. Feel free to share your score and how accurate you think it is in the comments section below.
That’s basically it. Determining your tolerance for risk ultimately involves looking inward and being honest with yourself about your goals and how you would react to the highs and lows of market fluctuations. Go through these steps and get a feel for where on the aggressive -> conservative spectrum you fall and next time we’ll get into the nitty-gritty details of actually allocating the assets in your portfolio.