How to Determine Your Risk Tolerance and Why It’s Important
By Matt Ward, CFP®, CRPC®
Planning ahead is crucial when it comes to investing. When investing, you want to ask questions like, what’s my time horizon, what is my risk tolerance level, how much do I need to accumulate, am I on track, what are my goals? The list can continue, these are just some ideas to begin with. Assessing your risk tolerance before a stock market crash is crucial. Don’t wait until the market crashes to think about your risk tolerance. That’s how lasting mistakes are made.
Questions To Ask
Here are some things to ask yourself when you first contemplate your risk tolerance. Before investing, it’s a good idea to make sure that you’ve met some of the financial essentials, such as building an emergency fund and paid off high-interest credit card debt. After you’ve met the financial essentials, all of the following questions will guide you to determine the allocation for your portfolio and the amount of risk that you need to take to achieve your goals.
What’s my time horizon and what’s my investment objective?
When it comes to investing, you should ask yourself 2 initial questions, what is my investment objective for this, and how long do I anticipate holding this investment? For example, is this money for your retirement? If so, you will want to look at your time horizon until retirement and how much you need to save to reach your goal. Another example, Do you want to take income from the investments at a future date? Or will you need the funds for additional educational expenses or perhaps to buy a home in the future? Depending on how will you use the funds and when your expected time horizon is will determine the overall foundation to your portfolio.
How much money do I need to live on?
The other initial question that you also need to ask yourself is how much money do you need to live on? What are your monthly expenses and how much are you able to pay from your salary? If your expenses are greater than your income, then you will need to find ways to cut costs or increase your income. For example, you can look at your spending habits and see if you are spending too much on unessential things.
Do I have any sort of insurance that may protect me such as disability or life insurance?
Depending on your age and financial debt-to-net worth, you should also have some form of insurance. These can be very valuable when you meet some kind of catastrophic life event such as a serious illness or job loss. It is always smart to ensure that you are protected financially, so please make sure you are covered. You should also check that your policy has sufficient coverage which may be 50% to 90% of your income depending on the type of insurance.
What are my short-term and long-term goals?
You should have a clear idea of what you want to achieve from your investment portfolio. The goals you set should be specific and measurable so that you can monitor your progress along the way and ensure you are investing in the right asset class. Also, make sure that your goals are realistic and can be achieved within the next one to three years. For example, you might want to purchase a car in the next one year or continue to save for the down payment on your dream house in the next 5. Or maybe you want to travel to Greece. Either way, defining a goal comes down to being specific and measurable.
How much money do I need to reach my goals and what are my current savings?
Once you have set your goals, you need to work out how much money you will need to achieve them. It is important to know how much money you will require to meet your short-term and long-term goals. Remember that in the short term, you may need to make regular deposits into your savings account or investment portfolio. You should also consider the potential returns of the investment and whether you can maintain your investments once you reach your goals. For example, if you want to buy a car in the next one year, do you know how much you will need? If your short-term goal is to travel, how much do you need to save? Looking at your short-term and long-term goals, how much money do you need to accumulate and how long will it take?
You also need to know how much cash you have available to allocate to your investments. This may be a good time to use a free cash flow spreadsheet to track the money coming into and going out of your bank account. At least, you will know what your monthly income and expenses will be.
How much risk do I need to take to reach my goals?
Once you know how much money you need to meet your goals and how much cash you have in the bank, then you should assess how much risk you are willing to take to reach your goals. You may have a goal of having $3,000,000 in the bank after fifteen years. How much risk are you willing to take for that to happen?
Once you have decided on the goals and how much money you will need, it is time to consider the potential returns you need to reach your goals, as well as the time frame in which you need to accumulate the money. You should ask yourself, “How much risk can I take to reach my goals in the time I have?” Most people would prefer to take a very safe investment such as a savings account or corporate bonds and avoid the high risk of the stock market. While it is important to set long-term goals, you also need to be aware of how much risk you need to take. Investing in volatile markets can be risky, especially if you are an inexperienced investor or if you will need to take the money out in a short period of time. It is important to have a balanced portfolio to mitigate risk. If you go into the stock market expecting to make money, you have to be prepared to lose money.
What will I do if I lose money?
Once you have decided how much risk you are willing to take, you need to consider what will happen if the market does not work out as planned. This could be especially true for young investors or those who are new to investing. If you are willing to take a lot of risks, then you should also be willing to lose a great deal of money if your investments turn south. One of the worst mistakes that people make is not having a plan for what to do if they lose money. If you have been a risk-taker, or have had some big losses in the past, then you need to seriously consider this question. Microsoft, a great company, was down for 15 years from 2000-2015. If you retired in 2000 with the expectation that holding Microsoft, which was growing enormously would pay off, you would have been wrong and possibly spent your money down. Mutual funds were up over 8% during that same time period.
What will I do if I make a lot of money?
This is the flip side of the previous question. If you are someone who makes a good living and it is possible that you could make a lot of money with your investments, then you should also consider what you will do if you make a lot of money. This is a much more pleasant thought to have, but it is still a good one to consider. If you do make a lot of money on an investment, will you take it out and spend it or will you keep it in cash or reinvest to keep it growing? How much money can you reasonably save or invest? Can you afford to spend the rest in order to meet your goals? These are questions you should consider.
What is my risk tolerance for my investments?
Your risk tolerance is a critical factor in determining how you can invest. Risk tolerance is your ability to handle volatile investments without getting nervous and making rash decisions. This can be tough to answer, but it is very important. If your risk tolerance is low, you should consider investing in safer investments that have lower potential returns. If your risk tolerance is high, you are more likely to have a higher potential return, but you have to be able to handle the potential losses that can accompany those gains along the way.
Looking at the numbers
Looking at the numbers, or looking at what your risk tolerance level is, can help you determine which investment portfolio is best for you. Often times reviewing the length of time a stock market crash lasts, or how your investments behaved during that time can help show that long-term investing works. Invest in what you know, and take some time to research what you want to invest in so that you make educated decisions. If the stock market is crashing and your investments are plummeting, don’t panic, use your knowledge and reason to assess your risk tolerance and make the best decision. If you are in a good, long-term investment that is going down because the stock market is going down, then you likely have a scenario where staying the course will work for you. For example, the average stock market crash can last for 6 months to 2 years.
Putting it all into action
Each of these questions on risk tolerance will have a unique answer, depending on the individual’s personal values, financial situation, and desired outcome. If an individual has over-saved or has enough other income for retirement, then their investment portfolio could be viewed from both lenses, conservative or moderately aggressive. Maybe this individual wants the money to go to a family member 1 or 2 generations down. Then they could afford to take more risk, because the time horizon is maybe 20 years or more. However, the individual may want to spend some or all of their portfolio, be uncomfortable with market volatility, and decide they want a conservative portfolio. That’s appropriate too. It depends on various circumstances.
Contact us for a complimentary risk assessment
If you’ve been wondering about the recent market volatility and want an honest opinion on your portfolio and risk level, then go to our website at www.newcenturyinvestments.com/contact-us or schedule an appointment online. New Century Investments is an independent investment advisory and financial planning firm serving business owners, pre-retirees, and retirees in the Dallas-Fort Worth area and beyond.
