Determining your risk tolerance is one of the first steps in choosing an investment that will impact your financial future.
When your financial goals are aligned, you’re better able to determine how much you’re willing to risk and how you’ll recover if it all goes south. Additionally, you’re in a significantly better position to choose investments that will meet those goals.
A comprehensive financial plan is a guide for assessing all types of risk, from buying that boat you’ve had your eye on, to buying shares in GameStop, or parsing out your estate plan. Strategy and Brand Advisor Chris Brogan famously said, “The goal isn’t more money. The goal is living life on your own terms.” How you process that concept may be a good indication of where your risk tolerance is on a scale of “financial safety net” to “high-risk, high-reward.” If your goal is financial freedom, you’re likely not willing to invest in anything that has a higher chance of neutral or negative returns.
Ultimately, age, investment goals, and how comfortable you are with volatility all play a part in where you fall on the spectrum. Just because you can recover from a significant financial loss, certainly doesn’t mean you want to.
What Is Risk Tolerance?
Risk tolerance is the degree of variability (aka loss) in investment returns you are willing to withstand in your financial planning. If you have a low degree of risk tolerance, your investments will likely be more conservative; if it’s high, you may be willing to put a lot on the line for the possibility of a big payday knowing you’ll be able to recover.
Bull markets can be great for investors, because the outlook is generally good. For some investors however, it’s a dangerous temptation. The S&P 500’s longest bull market in history lasted from March 2009 until March 2020, when it hit an abrupt end amidst fears stemming from the Covid-19 pandemic. Though the market has made incredible and unpredictable strides in the year after, aggressive investors had a lot to make up.
How Does Risk Tolerance Work?
When it comes to risk tolerance, investors are typically divided into three categories: aggressive, moderate, and conservative.
Aggressive Investors
We often visualize aggressive investors as Wolf of Wall Street-types. The focus of an aggressive investor is capital appreciation, a fancy term for money making money. A simple example is investing $1,000 in anything – stocks, for instance – where the value increases, say 50% to $1,500. That $500 difference is capital appreciation.
That is a very simple example and not likely indicative of the type of investment an aggressive investor would make – double, triple or quadruple those figures and one may get close. These investors favor equities, equity funds, and ETFs primarily because they have great value-earning potential, but they’re also incredibly volatile due to share price falls, lack of or lower-value dividends, and the potential for shake-ups at the company that make the stock less profitable. An aggressive or high-risk investor may have a portfolio allocation that is 85% stocks and 15% bonds.
A recent example is the failure in 2020 of Quibi, a smartphone-focused live streaming start-up headed by former Walt Disney Studios Chairman and film producer Jeffrey Katzenberg and former President and CEO of eBay and Hewlett Packard, business executive Meg Whitman. On paper, Quibi might have been attractive to an aggressive investor – it was led by seasoned executives in the tech space, backed by plenty of influential Hollywood heavyweights, and targeted the seemingly wide-open market of youthful, phone-obsessed Gen-Zers with bite-size entertainment. After six months, the company folded, taking with it nearly two billion dollars in investor cash.
Moderate Investors
Unsurprisingly perhaps, this type of investor falls in the middle of those willing to endure volatility for the possibility of both high returns and high loss, and those who want to protect what they have while also earning a higher-than-inflation, but not significantly higher, return. These investors favor preferred stocks, utility stocks, and income mutual funds, as well as real estate and blue chip stocks. For the most part, these types of investments are relatively stable and, with utility stocks for example, pay dividends of about 2% to 3% above treasury securities. A moderate risk investor may have a portfolio that includes 65% stocks, 30% bonds, and 5% cash or money market funds.
Conservative investors
These investors are more protective of their bottom line for many reasons, chief among them, they do not want or cannot handle significant losses. Many older investors fall into this category because they do not have the time needed (generally five to ten years) to recover from losses (or, get back to where they were). These lower risk investors favor bonds, bond funds, and ETFs because they tend to be more stable and consistent. A conservative portfolio allocation may have a mix that includes 25% stocks, 45% bonds, and 30% cash and money market funds.
How Do You Determine Your Risk Tolerance?
Being mindful of your risk tolerance doesn’t necessarily mean investing less, in fact, it really means investing smart for your specific financial situation. Many experts agree asset allocation is one of the most important decisions an investor can make, and this is the heart of risk tolerance.
Investors may be disappointed to know there is no magic formula to spit out the perfect mix of stocks or bonds that will keep your portfolio on a permanent, upward trajectory. Even Warren Buffett, so-called ‘world’s most successful investor’ has endured major losses, but what makes these losses important with respect to risk tolerance is that they didn’t represent the majority of his portfolio.
How you determine your tolerance for risk is to thoroughly understand your financial plan, be honest about your goals and aspirations, and don’t get caught up in the excitement of a prospective stock or investment opportunity without making sure it aligns with those goals.
Build Your Retirement With Investments That Matter
At Fullerton Financial Planning, our goal is to help you enjoy your retirement with confidence, not worrying about whether you have enough money to enjoy it. Our certified fiduciaries and experienced investment advisors have decades of combined experience helping people find answers to difficult financial questions. Sit down with a Fullerton Financial Advisor today to discover if you are on the right track for your retirement goals.
We understand how important your financial future is to you and your family; we also understand how difficult making these plans can be. If you aren’t sure what your risk tolerance is or if your financial plan matches your tolerance level, schedule a call with Fullerton Financial Planning, we’ll help you figure out what makes sense for your situation.
Don’t leave your financial future to chance. Let us help you create a personalized plan so you can enjoy the retirement you’ve worked so long and hard for.
