Investing without understanding your investment risk tolerance is a sure way to miss your financial goals and create sleepless nights.
Investment risk tolerance is one of the most important but overlooked concepts in investing. Investors eager to reach their financial goals for retirement or that dream vacation read through a few websites about stocks and bonds before putting their money in some popular funds or products.
Then the sleepless nights come as stocks turn skittish or bonds struggle along, barely earning a rate of return. What appeared like a diversified portfolio now consumes the investor’s thoughts and they end up making poor investment decisions like panic-selling.
The problem is that; while you may have bought a good mix of stocks, bonds and other assets, the portfolio wasn’t created for your own ability to handle risk. Your investment risk tolerance is your ability and willingness to accept fluctuations in your investments, and to do it without losing sleep. Risk is one of the key parts of investing, covered in a previous article: Investing Basics and Beyond.
It does you no good to jump into a set of investments if the constant ups-and-downs are going to drive you crazy. You’ll end up spending all your investment gains on medicine for high-blood pressure and nerves. On the other-hand, investing in super safe assets will make higher-risk investors impatient and may not help them reach their financial goals.
Figuring out your own investment risk tolerance, and the most suitable investments, is actually fairly easy. There are quite a few handy tools on the web and we’ll go through a list of questions below. It’s the first step in creating your Investor Policy Statement (IPS), a personal investment strategy that everyone needs before investing. We’ll work through the rest of the IPS in coming posts.
Questions to Ask to Decide Your Investment Risk Tolerance
Determining your investment risk tolerance is usually done through a set of questions, both data and hypothetical. Think about each and how it applies to your own risk tolerance. Each question is associated with a point scale. Give yourself one point for the first answer, two points for the second, and so on.
1) When do you expect to be using the money from your investments?
- Less than a year
- 1-3 years
- 3-10 years
- After more than 10 years
If you are going to need your money in less than a few years, your investment risk tolerance is going to be very low. You cannot afford for the stock market to take a nose dive and wait for the recovery. If you won’t need the money for decades, you can accept the ups and downs that come every 3-5 years. (Score from one to four points)
2) How important is it that you reach this particular financial goal?
- Couldn’t live without it
- I’ll get by but it will be difficult
- No significant change in lifestyle but I will be disappointed
The importance of reaching a particular financial goal is something most don’t think about with their investments. They lump investments for retirement and education in with their vacation money and everything else. You will be able to tolerate a little more risk, and potentially see higher returns, with less important financial goals. (Score from one to three points)
3) How long will you be spending money from the investment?
- I will spend it all immediately
- It will probably be spent between a year and five years
- I will be spending the money down over a long-term, greater than 10 years
If you are going to be needing all or most of the money at a specific date, or over a short period, then you will have less tolerance for risk. The tuition expenses won’t wait a few years for the market to recover. On the other hand, if you can withdraw money gradually and let the rest accumulate, you may be able to handle a little more risk. (Score from one to three points)
4) How often do you sell your investments after buying them?
- Usually within one or two years
- After three to five years
- I hold on to investments for a very long time, greater than eight or ten years
Notice there is no choice for less than a year, that’s not investing but gambling on the short-term craziness of the market. Active investors, those buying and selling more frequently, are usually able to handle a little more risk in their investments without losing much sleep. (Score from one to three points)
5) If a stock I owned lost 30% of its value over the course of a few months, as happened broadly in 2008, I would most likely…
- Sell all of the investment
- Sell a portion of the investment
- Sell nothing but do nothing
- Buy more of the investment
Be honest here. If you absolutely cringe at the idea of losing money in your portfolio, even if it is in just one stock, then your investment risk tolerance is low. There is nothing wrong with wanting the safe and steady. (Score from one to four points)
6) When the stock market is declining rapidly, I generally sell some of my investments to protect my money
- Yes, I sell a lot and feel better doing so
- I may sell some but am disappointed
- Really can’t tell what I would do
- No, I wouldn’t sell anything but I may be a little anxious
- No, I buy more all the way down and wait for the recovery
This is related to the previous question but a little more general. Think carefully about how you would feel, maybe using the past financial crisis as a guide. If you can really get by and not worry about your investments losing money for a period of several years, then you will be able to tolerate more risk. (Score from one to five points)
7) The chart below shows three portfolios with different risk and potential returns. Choose the one with which you would be most comfortable. For example, portfolio A may earn $593 but may lose $164 while portfolio C may earn much more but may also lose much more.
This question is pretty straight-forward. If you would feel comfortable risking the loss of nearly $4,000 for the chance to gain $5,000 then you are clearly able to tolerate more investment risk. If you would rather only risk a much smaller amount, and be comfortable if it meant only the possibility to earn lower return, then you are less risk tolerant. (Score from one to three points)
8) What kind of stocks do you generally prefer?
- High-growth companies making tech advances that could jump quickly
- Established companies with some potential for growth
- Mature companies that may not be headline news but pay stable dividends
This isn’t meant to pick stocks but to get a feel for the kind of investment in which you are comfortable. Shares of companies like Coca-Cola are not going to make you a millionaire overnight but the odds of losses are very low. Shares of that hot tech-startup could surge with a patent discovery but the company could also go bust, losing all your money. Which would you be comfortable putting your money in? (Score from one to three points)
9) What type of bonds do you generally prefer?
- High-yield bonds that offer high interest rates even if the company is less secure
- Tax-free bonds paying lower rates but backed by governments and cities
Even fixed-income bonds can be risky and attract a certain type of investor. Would you prefer the slow and steady of government-backed bonds, even if they don’t pay much, or do you need a little more risk even in your bond investments? (Score from one to two points)
10) My current and future income sources are…
- Uncertain, I work independently and income varies
- The industry in which I work is cyclical and layoffs are common
- Nothing is certain but I have good seniority and should not have to worry
- I have contracts in place that will nearly guarantee my employment or a strong severance
You need to balance your financial risk with your investment risk. Many that work in the financial markets, i.e. stock traders and advisors, have very little risk tolerance because their income is directly tied to the markets. A market collapse or recession may severely limit their income so they do not want to simultaneously suffer investment losses as well. On the other hand, tenured professors and others with contracted employment may be able to take a little more investment risk since their income is all but guaranteed. (Score from one to four points)
What is my Investment Risk Tolerance?
Adding up the points in the ten questions, you get a score between 10 and 34 points. You will find most investment risk tolerance calculators on the internet use some kind of a scoring methodology to place you within one of about five categories from very low tolerance to very high tolerance for risk.
With an idea of how much risk you can handle without causing much discomfort, you can start to look at different investments and proportions for your portfolio. No matter what risk category you are in, you always want some diversification across different investments like stocks, bonds and real estate but your own needs will determine how much in each.
The table below is not a hard-fast rule of how you should invest your money but a guide to consider your investment risk tolerance and different investment categories.
Alternative assets are investments like private equity, venture capital and hedge funds, investments in start-up companies and other very high-risk ideas. You’ll probably not want any of these investments if you do not like risk or need your money quickly.
Stocks are generally riskier than bonds and real estate but provide an excellent return over a long period. With interest rates on many bonds paying next to nothing, even the most risk averse person may want to hold some stocks.
Real estate is generally a fairly safe investment with steady returns of both price and cash. Because of the trouble getting your money out quickly, I would limit real estate investment to less than 15% or 20% of your total wealth.
Bonds are generally the safest investments, though you can buy “junk” bonds that pay high rates but are very uncertain. They will provide a stable return through cash payments and do not involve much risk.
Beyond these four categories of investments, check out the investment risk tolerance pyramid below that does a good job of defining and outlining other options.
Once you have an idea of your investment risk tolerance, you can start looking at other factors in your investor policy statement. We’ll cover the five most important factors in a post next week before moving on to figuring out your portfolio return and how to put investments together.