2018 has already surpassed 2017 when it comes to volatility in the stock market. Last year’s market was about as exciting as the Olympic qualifier for Curling, and this year is feeling more like an Alpine Ski Race at breakneck speeds. Now that investors have been reminded that stocks don’t always provide a smooth ride, many may be wondering whether they’re taking the right amount of risk in their investment portfolios.
Taking risk is an unavoidable aspect of investing. We tend to have a negative connotation of the word “risk,” but when it comes to investing, taking on a certain amount of risk is acceptable. In fact, if you don’t take on risk in your investment portfolio then you expose yourself to other types of risk: the risk that your savings will lose purchasing power due to inflation, and the risk that your savings won’t sustain you in retirement.
Still, even if you understand and accept that you should take risk in your investment portfolio, you may be unsure of how much risk you should take. This “how much risk?” question is referred to in the industry as an investor’s risk tolerance. The answer to the question can be boiled down to two factors: Ability and Willingness.
Your Ability to Take Risk
Your ability to take risk in your investment portfolio is completely dependent on time. In other words, how much time is there until you will need the money that you’re investing? For example, you are probably investing for retirement. If you’re 60 years old and plan to retire in the next five to seven years, you don’t have the ability to take the sort of investment risk that a 30-year-old might take with her retirement savings. At least, it would not be prudent to do so.
The reason that time is so important is that you often can’t control when you need your money—perhaps you have to retire at 65—and you certainly can’t control when your investments go up or down in value. You don’t want to be caught needing your money at a time when the market has fallen if your portfolio has taken on a lot of risk. This can have a serious impact on your ability to recover from investment losses.
Your Willingness to Take Risk
Your willingness to take risk can be tougher to determine. It comes down to whether you believe that you can stomach seeing investment losses in your account. It’s human nature to get caught up in the short term and lose focus on the longer-term goals, like retirement. It’s also natural to lose patience with an investment, even if it has done reasonably well, if you see something else out there that has had better performance recently. Your ability to overcome these emotions and biases and arrive at investment decisions objectively is what determines your willingness to take risk. You probably already see the flaw here: in practice, people don’t do a great job of determining their own objectivity. For that reason, it’s helpful to talk with a financial advisor to get a professional’s take on this.
What if Ability and Willingness Conflict?
It’s common to see investors who have conflicting ability and willingness when it comes to risk. An investor nearing retirement may be used to taking on investment risk and be reluctant to miss out on big market gains. On the other hand, an investor who has plenty of time until retirement might objectively be fine taking on more risk, but they might be more nervous about seeing their account value go down. Ultimately, an investor should follow whichever factor—ability or willingness—leads to a more conservative outcome. After all, it doesn’t matter if you have decades to absorb investment losses if your reaction to every market correction is to panic and sell low.
If you’ve read this and still have trouble assessing your risk tolerance, contact a financial advisor to explore the question further. It’s often the case that an investor has greater ability to take risk than they initially thought—perhaps you can rely on pension income for some of your retirement goals, for example. We also frequently see that an investor’s willingness can quickly change once they gain a better understanding of how investing works and what they can expect.
The conversation around risk tolerance is a critical conversation to have, and, in fact, it should never truly end. As circumstances in our lives change, so does our ability and willingness to assume investment risk.