Every investment requires the balancing of risk versus reward, which are inherently connected by definition. For investors, who are faced with a seemingly unlimited amount of options for where to place their monies, understanding their personal risk preferences will help guide the search for the most appropriate investments.
Defining a risk profile extends well beyond an individual’s personal tolerance, and should include an analysis of the investment objectives, a complete picture of their assets and liabilities, and the intended timeframe of their investment horizons.
What is Your Tolerance for Risk?
Everyone has a unique personality, and only you can say how much risk you are personally willing to stomach. Just because someone might take physical risks in their day-to-day lives does not mean that they should embrace a volatile investment strategy. For instance, parachuting out of airplanes as a hobby does not necessarily equate with an aggressive approach to investing money.
Highly risky investments go hand-in-hand with the potential for big gains. After all, who would not want to be one of the first investors in a Google (NASDAQ: GOOGL) or an Apple (NADSDAQ: APPL)? However, when considering this question, instead of focusing on the potential gains, make sure to think about how you would feel when confronted with a loss of capital.
For some individuals, a major hit to their portfolio would be a short-term set-back, an understood and acknowledged part of the long-term investment process. For others, however, this would constitute a brutal shock that would negatively impact their mood and behavior.
The idea of risk is another way of saying uncertainty, and this question really boils down to your ease with navigating the unknown. This is more art than science, but a number of financial advisors offer questionnaires that can help you consider your level of comfort with financial risk.
What is Your Capacity for Risk?
While it is related to risk tolerance, the capacity for risk is not one and the same. The capacity for risk centers on the tangible impact of potential losses that could occur throughout your investment journey.
It is therefore important to think about your current means and responsibilities. It follows that your circumstances can help you define your capacity for taking on risk.
For instance, an individual in their early twenties with minimal obligations would have a very different set of considerations than an individual who is in their mid-fifties with a mortgage and two children in college.
A young professional, with their entire working life conceivably in front of them–and without the responsibility of taking care of a family–can afford to take a greater set of risks with their monies. A loss would likely not materially impact their day-to-day existence, and they have plenty more years earning a salary to recoup their failed investment.
On the other hand, the middle-aged individual would be in a much different scenario. An aggressive strategy could backfire, diminishing accumulated savings and directly impacting their ability to make payments on their debts and obligations. In addition, as the number of prime working years begins to dwindle, there would not be much time to build back their savings from a loss.
For this reason, it makes sense to periodically review both risk tolerance and risk capacity to understand if these have shifted over the years.
What is Your Required Investment Risk?
Your tolerance and capacity for risk should not determine your investment objectives in a vacuum, and your required risks should be driving many of your investment decisions. For instance, if you have modest ambitions there is no reason to take unwarranted risks, even if you are in a position to do so.
In other words, let your destination guide the amount of risk you plan on taking. If conservative or even relatively moderate returns would suffice, there might not be a compelling reason to pursue an aggressive investment strategy.
For most people, as they inch closer to retirement, wealth preservation will begin to eclipse the importance of growing their capital. They will become more conservative, as the goal shifts to safeguarding the savings they have accumulated rather than the search for gains.
Creating a financial roadmap requires both an understanding of means and objectives. It is as true in life as it is with finances: unless you know where you are going, it will be difficult to make a plan for how to get there.
Conclusion: How to Invest Within Your Risk Profile
Your portfolio should be balanced with your desired level of risk, which can vary throughout your investment lifetime. Those who are just beginning to invest their monies can afford to take on a more aggressive approach, while those closing in on retirement should consider moving their funds into more conservative asset classes.
Whichever investment approach you decide upon, starting early is always recommended. The power of compound interest rings equally true for both conservative and aggressive investment approaches and levels of risk.
Whether you are investing in conservative vehicles like Certificates of Deposit, undertaking a 60-40 investment strategy, timing your investments through dollar-cost averaging, or going all in on growth stocks, the more time your monies are invested the better chances you will have to generate wealth.
Your comfort level with risk should drive your investment decisions. Understanding your desired level of risk can help create the right approach for you.
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