Risk is unavoidable when it comes to investing. And while you can't eliminate it, you can manage it. Smart financial strategies requires defining and understanding your risk tolerance, understanding your timeline and constructing a portfolio that addresses both.
What Exactly is Risk Tolerance?
Put simply, how much short-term loss are you comfortable with? If your portfolio dropped by 5% today, how well would you sleep tonight? Those of you who would be tossing and turning have a low risk tolerance. If you're sleeping like a baby? You can tolerate more risk, but that doesn't always mean that you should.
Why It's Important
If you generally have a lower risk tolerance, you'd likely prefer a conservative approach to investing that favors guaranteed returns, ease of liquidity and low risk to your principal. If you have a high risk tolerance, you may prefer an aggressive approach focused on maximizing returns, even if that means putting the principal at risk. It's important that you select an investment strategy that you'll be comfortable with but there are other considerations as well.
Why It's Not One-Size-Fits-All (or All-or-Nothing)
Investment strategies don't exist in a vacuum. There are no right or wrong answers when it comes to risk tolerance. Nor is it an all-or-nothing scenario; you shouldn't assume that your risk tolerance should dictate your investment approach for all of your goals.
Instead, you should take into account multiple factors, including:
Your Financial Goals
Is your end-game to establish a steady source of income in retirement? Or are you looking to grow your gains by leaps and bounds? Each goal will require fine-tuning your risk tolerance and investment strategy.
Your Overall Financial Picture
You should never view risk tolerance in isolation. Your total assets, income and debts should inform both your financial goals and your risk tolerance. If you have high income and multiple liquid assets you could sell in a pinch, for example, you can likely tolerate more risk overall than someone with no reserves and a tight budget.
Your "Time Horizon"
that is, how long you have to reach your investment goals. If you're embarking on your career and retirement is still far on the horizon, your retirement portfolio can probably tolerate more risk. If you're aiming to retire next year, however, you probably can't risk large losses, so a more conservative approach is appropriate for those assets you plan to use in the near term.
Your Financial Confidence
Some people are more risk-averse than others, and there's nothing wrong with that. Ultimately, you should have clarity around your finances. The potential gains of a higher-risk approach might not be worth the sleepless nights or chronic worry.
Putting It All Together
Risk tolerance should be an important part of your discussions with a financial advisor. By walking through the many considerations that shape this component of your financial plan, you can find the right balance for your situation.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This article originally appeared in Brainerd Dispatch on June 16, 2019. You may view the article here.
Bruce Helmer, a founding member of Wealth Enhancement Group, has been the host of the “Your Money” Radio Show for more than 20 years. He is also featured weekly on the Twin Cities CBS affiliate WCCO, and has penned three financial advice publications.