“Investments involve risk.”
Not a new concept for anyone who’s ever heard or seen a commercial from any financial adviser. But have you ever stopped to consider what risks they are talking about or how you can mitigate them in through your investment strategy?
In our last three posts, we talked about not following the crowd, buying value and diversification. Each is part of a risk mitigation strategy but determining the right amount of risk to take is the first step in the process. And that is what we will be discussing in this post.
Types of Risk
Tolerance to risk varies from investor to investor and is a very personal decision. However, there are common elements that each investor should take into account. The two most common are systematic and unsystematic risk.
Systematic risks are those that have effects on the entire market. Things such as wars, pandemics, and recessions are most common. Unsystematic risks are those that affect individual stocks and securities.
If you take too much risk, your portfolio is susceptible to marketing swings and may not leave you enough time to recover before having to begin withdrawals. On the other hand, if you don’t take enough risk, you could be missing out on long-term gains, leaving your portfolio vulnerable to inflation.
Portfolio diversification can help mitigate both systematic and unsystematic risks by dividing your eggs among several baskets, protecting the overall value from marketing swings.
Here’s where risk becomes personal, and you need to be honest about how much risk you are willing to take. No one wants their portfolio to lose money, but we all know that it will go up and down over time, so you need to ask yourself a couple of questions.
First, with your long-term goals in mind, do you could withstand swings in value and take the loses in order to pursue the returns. Second, how much risk is necessary in order to meet your goals. The answer to the first question lies within you, while the second can be answered by examining several factors. These include your expectations for return, investment objectives, time horizon and appetite for risk.
There are asset allocation tools you can use to help you determine the optimal level of risk and many of the most popular begin their calculations by considering your age or time until retirement. While both factors are useful, they are by no means the only and not even the most critical. Other factors to consider are your liquidity needs, net worth and investing priorities.
Take for instance the idea of decreasing investments in equities and increasing fixed income holdings as you approach retirement age. On its face, the strategy seems not only reasonable but perfectly logical, as well. However, if your allocation strategy is based on age, it is likely that it has not considered longer lifespans, and the effects of inflation. Ignoring both can put you at risk of running out of money.
Risk tolerance is a tricky thing to determine because it requires being honest with yourself and, if you don’t get it right, you could be leaving yourself open to missing out on gains or living through wild swings in portfolio value that have you reaching for the antacid.
Finding a financial planner to help you figure out what level of risk is right for you is a worthwhile investment of time and money.