In the investing world, risk holds two meanings: uncertainty and loss coupled with opportunity and growth.
When working with clients, I have a framework to ensure we’re taking an appropriate level of risk. We start with an advanced plan that outlines someone’s values and goals. Next, we gather quantitative inputs. This might be information about lifestyle costs, vision for retirement lifestyle, timing for retirement, and what gifts to charity or family are to be made during life or as a bequest.
Once we have a picture of what the current lifestyle looks like and what the future hopefully holds, we can answer three important questions.
1. How Much Risk Do You Need to Take?
Taking some level of investment risk is often necessary to reach your goals. For those who are more risk-averse, it’s important to know certain risks can hedge against other risks, like inflation being higher than expected or the risk of outliving your nest egg.
On the flip side, maybe you have reached your financial goals and no longer need to take the level of risk that you took earlier in your career. Remember the important adage, “never risk more than you can afford to lose.”
2. How Much Risk Are You Able to Take?
The ability to take risk has to do with several factors, including how long until you need to access the funds and your lifestyle costs. Stock markets can be volatile and can take a long time to recover in a recession. Could you adjust your lifestyle or continue working if we encounter another large loss in the stock market?
Investors who can weather the ups and downs without drawing money from a portfolio will have a better outcome.
3. How Much Risk Are You Willing to Take?
This last question relates to your mental threshold and can trump the other two.
Is there a level of loss in your portfolio that would keep you from sleeping at night? Or a level that would cause you to panic and sell your investment holdings? We don’t want to cross that threshold. Often, after we work through the first two questions, the third is easier to answer.
So, how much risk are you taking now in your portfolio? The first big indicator is the percentage of stocks (high risk, high potential reward) vs. the percentage of bonds (low risk, low potential reward). Other elements of your portfolio that can bring in additional risk are having a concentrated holding, using debt to buy investments, investing in a holding that uses debt (or leverage), or making frequent trades based on trying to predict the direction of the market.
Whether the word risk makes you nervous or excited, make sure that your investments match your plan.
“Never risk more than you can afford to lose.”