Understanding your personal tolerance for risk is an essential part of creating a well-allocated portfolio that will both meet your financial goals and allow you to sleep soundly at night.
Given the recent financial crisis, which has caused gigantic fluctuation in financial markets around the world, now is as good a time—or bad one—as it gets to re-asses where you stand on the risk spectrum and make sure your portfolio is well-allocated.
Daniel Moisand, a certified financial planner with Moisand Fitzgerald Tamayo, says he considers three factors in the equation: risk capacity, personal tolerance and client objectives.
Risk capacity may sound like tolerance, but it is more a mathematical concept because Moisand evaluates how much a client can afford to lose in their portfolio and still have enough money to make the math work. For instance, he says, a retiree spending roughly 10% of his net assets per year, has very little to no capacity for risk.
As for risk tolerance, Moisand says investors need to recognize how much volatility they are emotionally willing to endure. He adds one good thing about the current bear market as well as the bear market at the beginning of the decade is that it has helped people better gauge their risk tolerance for risk. “Until you lose money in the market it’s hard to know your tolerance.”
Finally, he says, your level of risk is also highly dependent on your investing objective. Perhaps the most important component of your investment objective is your timeline—more specifically how long until retirement.
Matt Sivertsen, a certified financial planner with The Planning Center, a fee-only registered invest advisor, says typically investors with a time frame of at least five years before retirement are in the accumulation phase and can afford to be aggressive with their investments. This means they can tolerate higher volatility and therefore can have anywhere from 80% to 100% in stocks, which are more volatile investments than fixed income.
Sivertsen says that by dollar cost averaging, or investing in regular increments over time, in bad years investors can actually get more shares in their portfolio.
He adds more moderate investors, who are either closer to retirement or still have substantial time before retirement but can’t stomach as much volatility should have less invested in stocks –in the range of 40% to 70%. That leaves 30% to 60% of their assets in fixed income.
“For more moderate investors this allocation is nice because you have enough stock to keep up with inflation but enough stability to get through years like this where market is down.”
Conservative investors, who, for instance, may already be in retirement or are by nature highly risk-averse, are often advised to have much smaller stock positions, generally 20% to 40% of their portfolio. While these portfolios will have very low volatility, Sivertsen, said it is important for investors in this group to make sure their portfolio is able to generate enough returns to keep up with inflation.
Regardless of how your asset allocation, Sivertsen believes the equities component of your portfolio should be broadly diversified both by market capitalization, which means having stocks in the small-, mid- and large cap categories, and global exposure, with about half in U.S. stocks and half invested in international stocks.
On the fixed income side, he looks at high quality bonds, such as Treasurys or high-quality corporate bonds with a short-term duration of about one to five years. These types of investors have a little volatility but are pretty secure.
M. Eileen Dorsey, president of Money Consultants agrees investors would do well to stick with safer, more traditional investments, specifically on the fixed income side.
“I would stay away from anything too fancy,” Dorsey says, adding that “people wanted more yield and in exchange took a lot more risk… that’s what got us into this mess.”
In addition to avoiding higher risk securities, Dorsey says investors should also avoid inadvertently scaling up their level of risk by buying and selling at the right times.
One mistake investors often make, she says, “is selling low and buying high. We see that over and over again.”
Moisand agrees this is a common problem among investors who often adapt a gambler's mentality; when things start going well they expect it to stay that way. “Instead of rebalancing their portfolio and taking some chips of the table they continue to ride it.”
On the flip side, he says, “When things look bad they get irrationally uptight about and sell out.”
Sivertsen says investors frequently make these mistakes in retirement plans such as 401(k)s where they aren’t getting adequate advice.
“They are constantly jumping around between investments based on emotions and doing the opposite of what they should be doing. They end up hurting themselves even though emotionally they are trying to help themselves.”