How much risk should you take in your portfolio? It’s one of the key questions I discuss when meeting with clients, and it drives the underlying asset allocation of your portfolio.
Everyone has a different amount of risk that they may be comfortable assuming when investing. How do you decide how much risk is right for you? Typically, there are three primary factors that dictate how much—or how little—risk you should have when investing.
Your Time Horizon
Your time horizon is essentially the amount of time you have to invest for a given goal. Generally speaking, the longer your time horizon, the more risk you may be able to accept. The money in your emergency fund has a very short time horizon because you may have to spend it immediately and should have no risk of principal. If you’re saving for your new child’s college education, you may have 18 years ahead of you and are more capable of handling a riskier asset allocation.
Generally speaking, no investor has a single time horizon. We all have a number of different savings goals that we may be working toward, and each of these goals may have a different asset allocation.
Your Risk Capacity
By risk capacity, I mean how susceptible you are to a major event that could jeopardize your financial plan. This could be a severe disability that could limit how much you’re able to work or possibly even force you into an early retirement. It could also be the death of a spouse or you may need to serve as the caretaker for a loved one that may fall ill.
These events are not only unpredictable, but they can also put a significant strain on your incoming cash flow. A tenet of financial planning is hoping for the best but preparing for the worst. How prepared you are for a worst-case scenario will dictate how flexible you are when it comes to taking on a riskier asset allocation.
Your Personal Risk Tolerance
How you feel about the possibility of seeing your principal shrink in the short-term is a key consideration when deciding how much risk is appropriate for you. If your portfolio fell 5% tomorrow, how would you feel? Would you be okay, or would you feel panicked and seek to escape the market?
We sometimes refer to this as the “pillow test.” If the markets fall significantly, would you be able to have a good night’s sleep? If the answer is no, then it may be time to take another look at the asset allocation in your portfolio.
The riskier an investment may be, the greater the potential gains—or losses—that you may experience. Considering these three factors can help you and your advisor be more precise when finding the right amount of risk for you.
This article originally appeared on February 19, 2017 in the Des Moines Register. You may view the article here.
CFP®, MBA, Series 7 Securities Registration,1 Series 66 Advisory Registration, † Life & Health Insurance License As a CERTIFIED FINANCIAL PLANNER™ professional, Jim brings an extensive retirement income planning background to the team. He regularly writes a personal finance column for The Des Moines Register’s Business...Read More