The word “risk” typically has a negative connotation. That’s unfortunate because some degree of risk is necessary to grow your wealth and live the way you hope to in retirement when it comes to investing.
The question is: How much risk can, or should, you take on?
The answer will be different for every investor, and it will affect how you should allocate your assets and what kind of returns you can expect. While higher risk often means higher reward, it’s prudent to balance the desire for high returns with the need to feel confident enough in your financial plan that you can stay the course even when the market is volatile.
These three interrelated factors play a role in determining how much investment risk you should take on.
1. Your Investment Time Horizon
How many years until you will retire? That’s one of the biggest determinants of the degree of risk you can afford to take with your investments.
Generally, younger investors can take on more risk because they have more time to make up for losses caused by market downturns. In turn, that impacts how younger investors should allocate their investments across different types of assets, such as stocks and bonds. The greater your exposure to stocks, the greater your risk. So if retirement is still many years away, a strategy of 90% stocks/10% bonds or 100% stocks could be appropriate for your retirement accounts.
As your time horizon decreases, so should the amount of risk you take. Older investors typically can take on less risk because they’re closer to when they’ll begin drawing down assets in retirement. To avoid the risk of withdrawing funds when asset values are down, you may want to dial down your exposure to stocks as you approach retirement. While time horizon shouldn’t be the only driver of your asset allocation, a strategy between 60% stocks/40% bonds and 70% stocks/30% bonds is often suitable for people who are five years or less from retirement.
Investing for retirement may be one of your most important financial objectives, but you also may be saving for shorter-term goals. If you’re putting aside funds to purchase a vacation home in the next couple of years, you may consider keeping the money in a low-risk account like a money market or short-term bond fund. For mid-range goals, like saving for a child’s college education, you may be able to afford to take on more risk in the early years and less risk as you get closer to that first tuition payment.
2. Your Risk Tolerance
How do market ups and downs impact you emotionally? Are you likely to keep a cool head and stay invested during the market’s inevitable gyrations, or are you more apt to sell stocks and equity funds when the market drops?
If you find it difficult to answer those conceptual questions, think about it this way: What would you do if the market corrected by 20% or 30%? Would you invest more to take advantage of low share prices, sell stocks and equity funds because you fear the market might drop further, or do nothing at all?
For some investors, the fear of losing money is a stronger motivator than the anticipation of gains. If the market declines and their assets lose value, they’re likely to sell—even if they don’t need the funds for decades. Those investors are considered to have a low tolerance for risk.
If your risk tolerance is on the low end of the spectrum and you take on more risk than you should, you could end up selling assets at a loss during a market correction—locking in losses and reducing your portfolio’s long-term growth. If that would be your tendency, then you may be better off allocating a smaller percentage of your portfolio to higher-risk assets like equities and keeping more money in lower-risk assets like bonds.
Conversely, suppose your risk tolerance is on the higher end of the spectrum and you’re able to stay invested in the market even during times of volatility. In that case, you can consider allocating more of your portfolio to individual stocks and stock mutual funds.
3. Your Risk Capacity
Risk capacity means your ability to withstand losses if your investments decline in value. Whereas risk tolerance is psychological in nature, risk capacity is quantifiable.
Several factors influence your risk capacity, including the total value of your investment portfolio, the amount of cash you need for living expenses, and how soon you need to draw down those assets.
For example, if you have a sizable investment portfolio, your mortgage is paid off, and you’ve finished paying for your children’s college educations, your capacity to take on risk—or your ability to withstand losses—will be greater than if you still have a mortgage, you’re currently paying educational expenses, and your portfolio is modest but growing.
Your job situation also can impact your risk capacity. If you work for a stable company in a growing field, your risk capacity will be higher than if you run your own startup company, you don’t expect to draw a salary soon, and you need to dip into savings to cover your living expenses.
Don’t Forget About Inflation
Regardless of your investing time horizon, risk tolerance, and risk capacity, one factor that impacts every investor from a risk perspective is inflation.
If you take little or no investment risk, inflation could erode your purchasing power. That’s especially true during high-inflation periods like we’re experiencing now: Given that the inflation rate is much higher than the average CD or money market rate, keeping too much of your money in these low-risk investments makes it tougher for your total portfolio to keep pace with the rising costs of products and services.
As with most financial decisions, there is no one-size-fits-all answer when it comes to determining how much investment risk you should take on. The best approach is to develop a financial plan and investment strategy that takes a holistic view, factoring in your investing horizon, risk tolerance, and risk capacity to determine the right degree of risk for your situation.
To develop or fine-tune a financial plan that reflects the right degree of risk for you, contact the fee-only financial advisors at Team Hewins for your complimentary portfolio review.
Team Hewins, LLC (“Team Hewins”) is an SEC registered investment adviser; however, such registration does not imply a certain level of skill or training, and no inference to the contrary should be made. We provide this information with the understanding that we are not engaged in rendering legal, accounting, or tax services. We recommend that all investors seek out the services of competent professionals in any of the aforementioned areas.