Investing Risk: How Much Is Appropriate?
Finding an appropriate investment strategy is not simple, especially if investments are not your forte. Everybody wants that ideal investment that grows steadily but doesn’t decline in value. Outside of Bernie Madoff’s strategy, that doesn’t really exist, and most people are aware of a tradeoff between risk and return. In order to achieve your financial goals, there needs to be some assumption of risk. There is the risk that your investments decline in value which is where most people focus. And then there is the risk that an investment strategy is too conservative, thus exposing a portfolio to the risk of inflation. An understanding of this concept then begets the question of just how much risk one is comfortable with. There are two forces at play when making this decision: your tolerance for risk and your ability to take risk.
From a personal standpoint, I have always had the Evel Knievel gene. I love seeking out the biggest and scariest rollercoasters and in my younger years, I made the decision to jump out of a perfectly good airplane. Quick aside: for those who have never done it, it is an experience unlike any other. But times change. I wouldn’t dream of doing it now for a simple reason: I have a family that depends on me. Being young and single afforded me opportunities to take those risks and skydiving marked the confluence of a high tolerance and ability to take risk. My tolerance is still there, but my ability is greatly diminished.
With that in mind, let’s focus on investments. A common rule of thumb for choosing an allocation for your investments is that your age roughly equals the percentage to allocate to fixed income with the remainder to be held in stocks. As one ages, the more conservative a strategy should become. An investor’s age and years until retirement are two of the inputs in the ability to take risk, but this is where that heuristic falls short. Availability of other forms of income (such as a pension or business interests) during those retirement years can add to one’s ability for risk. If your goal is a large inheritance for your heirs and you live an appropriately frugal lifestyle, you have more ability to take risk than those who plan to deplete their investments. Underlying all these factors is time. The longer you can stretch the liquidation phase, the higher your ability to assume investment risk.
The ability to take risk is easy to quantify especially if you are working with an advisor. How much risk you are comfortable with is a much more personal decision. I have dealt with clients in their 20’s and 30’s whose investment experience has been scarred by some combination of the Global Financial Crisis and the COVID-19 pandemic. After experiencing two dramatic resets of their portfolios, they are hesitant to dive headfirst into the deep end. I have also dealt with clients well past the commencement of their Social Security benefits willing to dial their risk up to 11. As I have said before, the best investment strategy is one you can stick with through the good times and especially the bad times. If your portfolio is making you lose sleep at night, chances are you are invested too aggressively.
A regular review of a financial plan boosts the awareness of both variables in this equation and that is why having one is essential to your financial health. Not only can you monitor the qualitative and quantitative factors that determine the risk level in your investments, but a financial plan allows you to view your investments as a part of a bigger picture. A siloed view can cause you to focus on the wrong things at the wrong time which can lead to bad decisions. As always, our team is here to help with any questions you may have.
Author: David Rath, CFA
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