When you hear the word “risk,” are you filled with excitement or overcome with dread? Do your shoulders tense up? Or are you see a spark of opportunity?
Your risk profile is critical for building a long-term investment strategy that helps you reach your goals, even with unsteady market activity.
In this article, we provide risk tips, examples, and definitions that will make you a probability master, including:
- The difference between risk tolerance and risk capacity
- How to uncover your personal risk profile
- Tips for embracing risk in investing
Ready to find the risk level that’s right for you? Let’s dive in!
What is Risk Tolerance?
Risk tolerance is the amount of risk you feel comfortable assuming within your investments. It also measures the amount of volatility you’re willing to take on.
Could you sleep soundly if your investments dropped 20% overnight? What about 10%?
Even though everyone hopes for as little fluctuation as possible, volatility is an innate part of investing, so it’s essential to discover the levels you’re comfortable with.
Risk tolerance is a critical component of investing as it can help inform the type and amount of investments you choose—asset allocation. Typically, more volatile assets like equities are considered riskier than fixed-income investments like bonds.
For example, a portfolio comprised of 90% equities and 10% fixed income could be an example of a high-risk tolerance. But high-risk tolerance can also lead to a higher probability of growth. Generally, an equity-based portfolio will likely grow more aggressively over time than a fixed-income-weighted portfolio.
However, risk tolerance isn’t the only level you need to monitor.
Where your risk tolerance measures your unique penchant for risk in investing, your risk capacity is your ability to take risk, or how much risk you can afford to take as an investor.
And these two metrics may be at odds.
For example, you may have a relatively low risk tolerance. But if you want to retire early, your growth needs may require you to take on more risk to reach that particular goal.
Conversely, you might have a high-risk tolerance, but your situation requires you to take on less risk than you want.
Instead of a “gut check” like risk tolerance, your risk capacity denotes how much risk is appropriate based on your goals. Several factors come into play, including:
- Financial goals
- Time horizon
- Season of life
- Other sources of income (guaranteed income like Social Security, pension, annuities, etc.)
Here, you’ll ask yourself, what rate of return do you need to reach your goals? We can reverse engineer that to determine how much risk you should accept to meet your current goal and timeline.
Discovering Your Risk Profile
Your risk tolerance and capacity play critical roles in your retirement plan. Knowing your risk levels enables you to grow your investments while keeping your stress levels steady.
Finding the line between what you’re comfortable with and what you can afford is key to pushing yourself into the right investment strategy. A financial advisor can help you walk through this process and set you up for a fulfilling retirement—even if that means embracing more risk than you’re used to.
After all, a zero-risk tolerance policy won’t help your money grow!
3 Levels of Risk Tolerance
An excellent way to think about risk levels is by putting a “face” and personality to the description, like a character in a novel.
Before you choose your risk “character,” make sure you fully understand each risk archetype.
Investors in this category are willing and able to risk short-term volatility for long-term growth. They allocate most of their portfolio to riskier investments like equities, real estate, and other avenues. These assets offer potentially higher returns in the long run at the cost of greater interim volatility.
Who usually falls in this category?
Younger investors in their 20s and 30s can load up on risk because they have enough time to ride out the inevitable highs and lows.
Older retirees (80s and 90s) looking to leave a legacy for heirs may also have higher risk levels. These folks often have guaranteed income sources and enough investments to last a lifetime. Now, they may want to turn their attention to the future and focus on investment growth for future generations.
Moderate Risk Tolerance
Moderate investors land right in between aggressive and conservative levels. They tolerate some risk but not as much as the aggressive investor. These portfolios usually still favor equities but pepper in more fixed-income options. This combination creates a balance between investing money for growth (stocks) and keeping an eye on stability for generating income (bonds).
Who usually falls in this category?
Middle-aged investors in their 40s to 50s are usually moderate investors. These investors are likely in their peak earning years, although their financial expenses may also be high (ex: college tuition for their kids).
Conservative Risk Tolerance
Investors with a conservative mindset take on the least amount of risk. Instead, they are focused on the preservation of capital and income generation. These investors settle for lower returns to steer clear of any wild swings in value. Conservative asset options usually include bonds, consumer goods stocks, and utilities.
Who usually falls in this category?
Early retirees tend to see a drop in risk tolerance. As they’re creating a retirement spending plan and drawing down their nest egg, they want to ensure they have enough to cover their ongoing expenses for life. The first few retirement years are crucial for managing risk and volatility.
What Are Your Risk Preferences?
Now that you know the levels of risk to choose from, it’s time to discover which best suits your lifestyle.
Review the following questions:
- In how many years will you begin making withdrawals from your investments?
- Approximately how many years will you be making withdrawals?
- Is protecting your portfolio more important than high returns?
- Do you predict your income level to stay the same, increase, or decrease over the next few years?
- What do you expect to be your next significant expenditure? Buying a house, paying for your child’s college tuition, providing for retirement?
- What are your estate and legacy goals?
It’s important to be honest with your goals, feelings, and preferences as you manage your risk levels.
Don’t just accept the recommended level of risk for your age group. Instead, work with your financial advisor to design a plan that is the perfect balance of risk for your comfort level. It might be much higher (or lower) than you think!
When Risk Might Be Required
It’s nearly impossible to create a risk-free retirement plan, and most investment opportunities inherently carry some risk.
Additionally, everyone has their own unique retirement goals to work towards. How you invest should directly tie to the lifestyle you want. But to increase the chance of future earnings, you may need to assume more risk.
For example, a U.S. treasury bond is a conservative investment with an almost guaranteed rate of return. The promise of the return is reassuring, but the low earning potential (treasury bonds earn much lower rates of return than stocks) can be a drawback.
The key to balancing risk and reward? Diversification.
Diversification is the method of spreading your funds across different investments to limit your exposure to any single type of asset.
Diversification is an excellent way to reduce your portfolio’s volatility while still allowing for investment gains. If one stock does poorly, your portfolio will only be minimally affected because your other assets will be able to help make up for this loss. As a result, you get the benefit (and relative safety) of having both volatile stocks and safe bonds in your portfolio.
When you diversify your portfolio, you bring structure and balance to your investments. This strategy can help you reach your goals without stepping outside your risk profile.
Your risk capacity will likely change over time, depending on your season of life.
Nonetheless, it’s important not to let your fluctuating risk capacity negatively impact your investment strategy. Often, embracing risk (within reason) can be a good idea.
It can help you carefully craft a plan that sets you up to reach your goals. As always, there’s a careful dance between how much risk you want to take (risk tolerance) and how much risk you can afford to take (risk capacity).
Your financial team can help you strike that balance.
We Can Help You Think About Risk in the Big Picture
Don’t let fear stop you from having the retirement lifestyle of your dreams.
At Goepper Burkhardt Wealth Management, we can help you find the best way to invest and diversify your portfolio so that you can thrive financially and emotionally. Retirement is all about playing the long game, and we’re ready to guide you every step of the way.
Our experienced financial advisors know how to find the plan that is the perfect balance of risk for your comfort level. We will empower you to stay on course, trust your investment strategy, and prevent the market highs and lows from influencing your investing decisions.
Ready to feel confident in your financial strategy? Reach out to us today to get started.
Updated September 2022