How much risk are you comfortable taking with your investments? This key question in portfolio construction is very difficult to answer, given a world of high volatility in stock returns, constantly-changing economic conditions, and the fact that none of us can say with certainty how any financial asset will perform in the future!
Financial experts often break down an investor’s risk tolerance into three categories: need to take risks, the ability to take risks, and willingness to take risks. The “need” and “ability” factors are a function of one’s financial situation – for example, a retiree with a multi-million dollar investment portfolio and no need for portfolio income has a very high ability to take the risk (his/her life isn’t negatively impacted if the portfolio drops in value by a lot), and a very low need to take the risk (earning high returns won’t impact the standard of living). In fact, we find that for many investors, the “need” and “ability” factors merely offset one another. As such, we turn to the critical third factor, one’s “willingness” to take risks.
Another way to think about willingness to take risks is how various levels of declines in your portfolio impact your ability to sleep at night. Do you shudder with fear if you hear that the market is down 3% today? Or, do you welcome these downward movements, believing that what goes down will soon go back up?
We encourage investors to try to quantify their willingness to take risks by thinking about the maximum portfolio value that they could emotionally tolerate losing in a down-market. When considering this, try not only to think about your reaction but how such a drop would impact your financial life, if at all. For example, a 30-year old investor with stable employment may have a difficult time stomaching a 20% loss on her retirement portfolio, however, such a loss will likely have little impact on her financial future, as she still has a lot of time prior to needing the money.
Once you settle on a maximum tolerable loss, we suggest that you consider an investment portfolio that has at most two times that maximum loss invested in risky assets, such as stocks, real estate, high-yield bonds, commodities, etc. In other words, if you believe you can tolerate a loss of 20%, we recommend that you hold no more than 40% in risky assets. This follows from the notion that you should be prepared for risky assets to drop in value by 50% from time to time. We’ve seen broad stock market indices suffer losses of this approximate magnitude 3 times in the past 50 years (2007-2009, 2000-2002, and 1973-1974), and it will likely happen again. We suggest that the remainder of the portfolio assets should be invested in relatively safer alternatives, such as cash equivalents or investment-grade bonds.
Please review your portfolio or consult your financial advisor to determine if your current mix of investments aligns with your tolerance for risk.
Daniel Bauer is a principal and Vice President of AllSquare Wealth Management, LLC. AllSquare Wealth offers financial planning, investment management, and risk management services to clients located in the Capital Region and beyond.
AllSquare Wealth Management, LLC is a registered investment adviser.