How Much Risk Should I Take?
Ahhhhhh, risk and reward. Always the teeter totter of investment conversations. When it comes to investing, we all want to have our cake and eat it too. Meaning we want the maximum return - all the upside in the market. And we want nothing to do with the risk - when the markets go down. Who wouldn't want that?!
Unfortunately that's not how the markets work. In order for our money to grow, we have to also accept the very real possibility that it will (at times) shrink. And the more or quicker we want it grow - meaning the higher the rates of return - the more risk we (generally) have to take on. And the possibility for bigger gains also comes with the possibility of bigger losses.
Ugh. Definitely not having our cake and eating it, too.
And therein lies most investors' biggest question: how much risk should I be taking?
This is one of my favorite questions and before I answer it, I want to provide some reference. First, we're talking about long term investments, money you won't need for 10+ years. Think 401(k), IRA, etc. If you're saving money for a down payment on a house or some other short/middle term goal, there's a separate conversation to be had around that. Cool? Cool.
Here's how conventional advice frames our question:
Younger or just getting started = Ramp up the risk
Why? Conventional advice tells us if we're in our 30's and we don't plan on retiring until 30+ years later, we can afford to take a LOT of risk. This is for a few reasons:
We don't need the money anytime soon
When the market goes down, because we don't "need" the money in the near future, we can allow our money time to recover from the market dip
So in this case, we'd hold a portfolio consisting mostly of stocks (mutual funds, exchange traded funds, etc). Probably a smaller portion of bonds or bond funds (<20%). Conventional advice tells us to be aggressive to very aggressive because time is on our side. I don’t disagree with this reasoning.
Now let's go to the other end of the spectrum.
More Mature or Rearing Retirement = Go easier on the risk
Why? Conventional advice tells us if we're getting close to retirement we ought to ease up on the risk. Again, we can point to a few reasons for this thought process:
We'll likely be needing to use our assets (our investments) to provide income sooner than later
Since our money needs to last for an unspecified period of time, and we'll likely be drawing from it, we likely can't afford or tolerate (read: behave) wild swings or drastic declines in our nest egg
This example would have us holding less stocks and more bonds than our younger selves as bonds generally provide more of a buffer against market losses. Again, I don't disagree with this reasoning.
Here's the thing. Risk tolerance or risk avoidance varies in everybody. We all have our own capacity and tolerance. If you want to learn more, here's an excellent article on it by Michael Kitces. It really dives into it from a technical perspective, so peruse at your own leisure.
As I mentioned above, the guidelines are based on conventional advice. It assumes because you're young and time is your friend, you should take a lot of risk. And on the flip side, it also suggests that when you're older and time is not your friend, you should ease off the risk. Great rules of thumb, but conventional advice is for the masses and your financial plan is for YOU. Let's discuss.
We'll start with my house and our decision process around risk.
My wife is Risk Averse. She hates risk. She'll take the sure thing (most) every time. I shudder to think what our conversations would be like if she followed the market on a regular basis. And if I put her on the traditional risk tolerance questionnaire, she'd fall into a Conservative portfolio every time. Actually, she does and she did.
I fall between Risk Tolerant and Risk Averse. I share qualities of both. You could classify me as a Moderate Investor.
We're both in our 40's. Conventional advice says we should take LOTS of risk because we have LOTS of time. On the other hand, our Risk Profiles suggest we shouldn't.
Hmmm, this is a conundrum. What to do, what to do?
We opt(ed) to take a more aggressive approach than the risk profiles suggested. Not because it's what we should do or what conventional advice tells us. Rather, we did and do it because we both understand how the markets work. We know when the markets go down - which they will - we have time on our side. We also know OUR BEHAVIOR around our investments is the most important factor in determining our investment success. So we take a little more risk than our risk profiles tell us we should. And then we ignore the financial media.
Enough about us. This article is about how much risk YOU should be taking. I'll tell you.
You should take as much risk in your portfolio that allows you to behave when the markets do what they do.
Staying invested through the ups and downs allows you the best chance to capture the returns the markets have to offer. I can't tell you how much that is but having conversations with a financial planner can certainly help you figure it out.
Now that we know how much risk we should take, let's talk about a couple of scenarios that go against conventional advice.
Let's say you're in your 30's. Conventional advice says you have time on your side so you should take a lot of risk. No arguments there. However you are more comfortable with an investment mix that's 60% stocks & 40% bonds*. Cool. Rock it. Own it. Is it possible you could leave higher returns on the table? Absolutely! No worries, though.
Investing in the less aggressive portfolio allows you to do two things:
a) stay invested
b) capture all of the market returns
Investing in the more aggressive portfolio might cause you to panic and get out of the market at the wrong time. This could also mean you miss out on the higher returns that more aggressive portfolio could provide. Because if you can't stay in the market and ride the waves, what good is the more aggressive portfolio if you're standing on the beach wondering when to get back in the water? How many awesome waves will you miss?
On the flip side, maybe you're in your 50's, getting closer to or nearing retirement. Again, conventional advice says we have less time on our side and we should hedge conservative in our investments. Still no argument with those points. But you're more comfortable with an investment mix that's 80% stocks & 20% bonds*. Right on. Again, own it! Could we see our portfolio go down in value more than if we were in a more conservative portfolio? Absolutely. That's risk. As with our example above, understanding the risks involved is imperative. And understand what it means to be in the market and behave.
At the end of the day, conventional advice serves as a guide, and that's it. Its purpose is to provide advice to a mass audience. Your risk tolerance and capacity for risk is yours and yours alone. Be sure to match up your investments so you can ride all the waves. How?
Find a risk tolerance questionnaire online (pdf version and electronic version)
Work with a financial planner who can help you clarify where you want your money to go, and why.
Develop and follow an Investment Plan or Investment Policy Statement.
*suggested portfolio allocations above are not a recommendation