If you’ve ever watched Deal or No Deal, Jeopardy!, or any other game show, you’ve most likely noticed that each person can tolerate varying degrees of risk. Some contestants are willing to risk a large sum of money to potentially win an even more substantial amount, while others are content to walk away with the money they’ve already won – despite having a chance to increase their winnings. For investors, risk is often known as “the greater the risk taken, the greater the potential reward.” However, the potential investment costs are an equally important part of the equation.
Risk, and how much of it an investor is willing to accept, helps determine an individual’s investment portfolio makeup. That’s why modern investing theories suggest that there is no universally perfect portfolio. Instead, each investor’s portfolio should be able to handle a level of risk that aligns with their tolerance and the constant movements of the market. At Strategic Wealth Partners, we take the risk implications associated with different investment classes into account when constructing portfolios. If an investor can tolerate higher amounts of risk, their portfolio will likely have a more substantial equity presence than bonds or treasury bills.
So what do investors have to consider when looking at risk? While there are endless qualitative and quantitative factors that play into assessing risk tolerance, below are four of the most prominent:
Generally, people tend to want less risk in their life as they age. This is mainly due to changing priorities. As someone ages, there is typically a shift in a person’s focal point toward retirement and therefore a more significant concern on preserving their nest egg than growing it. For younger investors, there’s a longer time horizon until, hypothetically, they need to access their investments. Consequently, younger investors can often carry more risk in their portfolios.
2. Future Earnings
Investors should always have an eye on the future. Earnings and income streams are part of that picture. Younger investors may see consistent or steady increases in compensation as they age and have more time to use those dollars for growth and accept the risks of being in the market. For example, young law or medical students might be willing to take on a substantial amount of risk, even if they’re in debt up to their eyeballs, since they know their compensation will most likely increase exponentially once they reach the working world.
3. Investment Experience/Knowledge
Those with more financial education or investment experience tend to have a higher tolerance for risk, based on their understanding of how the financial system operates. The familiarity of the situation or financial instrument usually eases the investor’s level of concern and may allow them to take on a higher level of risk.
4. Life Events
So many other circumstances can influence risk tolerance. Perhaps someone just became a new parent, knows an inheritance is coming soon, or will be accessing a pension in a couple of years. These are just some of the situations that also have an impact on risk tolerance since they all represent significant financial changes.
Understanding how to assess risk tolerance is critical when looking at investing, but the real value is what you do with that information. Use this information to talk with your advisor about your risk profile. Discuss what your goals are and your current life stage. It’s also important to remember that risk tolerance levels are not static and periodic reviews can help ensure you are not taking more risk than your comfort level allows.
Just as in Deal or No Deal or Jeopardy!, we all can tolerate varying degrees of risk when investing our money. Ultimately there is no exact formula since risk appetite falls along a broad personal spectrum. At Strategic Wealth Partners, we love helping people uncover their risk tolerance and align their portfolio accordingly. Please reach out to us if you would like to learn more.