Everything in life has risks. But your risk tolerance isn’t always the same. While there may be some areas where you can take a lot of risks, there are other areas where you really shouldn’t.
For example, when you go to an interview, you risk not getting the job. When you ask someone on a date, you risk rejection. When you start a new business, hobby or side-hustle, you risk failing. Maybe in these circumstances, you’re confident, not as afraid of failure or understand what the rejection will do for you.
When it comes to investing, on the other hand, that may be completely different. Just because you may consider yourself a risk-taker, your financial future may not be something you want to gamble as aggressively. Financial planning risk is different.
It’s easy to find a free, quick, 5-question risk questionnaire to see where your financial risk tolerance may fall, but those tests don’t even scratch the surface. The best way to find your true financial planning risk tolerance is to discuss your situation, your concerns, your goals and your short-term plans with a financial advisor you can trust. If you’re looking for a financial advisor in Baton Rouge, schedule a free, no-strings-attached conversation with us. At Align Wealth Partners, finding your true risk tolerance is at the heart of everything we do.
No matter what you do with your money, there’s always risk involved. (Yes, even keeping your money in a savings account earning a guaranteed 1.5 percent return runs the risk of losing value due to inflation.)
Let’s take a look at the types of risk tolerance and how it guides your decision-making process.
What Is Risk Tolerance?
Risk tolerance is the variability an investor is willing and able to take in their portfolio. The answer drives how you should invest. If your risk tolerance is low, you choose a more conservative investment strategy. Maybe one that’s focused on low-risk bonds. If it’s high, you can get more aggressive.
Your risk tolerance is highly personal because it’s made up of these factors:
- Age: When you’re young, you may be in a position to take on more risk because you have more time to ride the waves of stock market volatility. When you’re retired, that’s not usually the case.
- Goals. Calculate how much money you need to reach your financial goals. Then, find an investment strategy that produces the necessary returns.
- Timeline. How soon will you need your money? If you’re 30 years old and saving for retirement, you may have 35-plus years to let market volatility and compound interest work their magic. However, if you’re saving for a down payment on a house that you hope to buy in five years, an aggressive investment strategy could lose you money when you need it most.
- Comfort level. Some people have a natural tendency to take on more risks than others. If stock market volatility stresses you out, an aggressive portfolio may not be worth the worry. The key is to strike a balance between risk and potential reward.
As an investor, let these factors help guide your investment strategy. If you take on more risk than you can handle, you’ll likely panic and sell off investments as soon as things go south (which could do more harm than good).
If you’re not sure what type of financial planning risk tolerance you have, consider working with a fiduciary financial advisor who can help you figure it out.
3 Types of Risk Tolerance
Investors generally have a low, medium or high-risk tolerance. Let’s take a look at each.
Low-Risk Tolerance: No Big Risk, But No Big Gains
Those with a low-risk tolerance tend to have a conservative investment strategy. They shy away from stock market volatility and, instead, favor investments with low (but predictable) yields.
A typical investment portfolio for a low-risk investor might be 20 percent stocks and 80 percent bonds. With this allocation, you may see an average return of around 6.1 percent, or 2.88 percent after inflation (based on a 3.22 percent average inflation rate).
- If you had a $100,000 investment in this portfolio, you’d have $234,384.38 after 30 years.
A conservative investment strategy may be ideal for retirees, but not so good for young investors who have decades to build wealth.
Medium Risk Tolerance: You May Think You Can, But Should You?
Investors with a medium risk tolerance typically have balanced portfolios. They may split their money up between large-company mutual funds and low-risk bonds to ensure they’re not carrying too much risk at once.
If a medium-risk investor has a balanced portfolio of 50 percent stocks and 50 percent bonds, they may expect an average 8.2 percent return, or 4.98 percent after inflation (based on a 3.22 percent average inflation rate).
- A $100,000 investment in this portfolio would be worth $429,731.37 after 30 years – nearly $200,000 more than the conservative investor.
This strategy may be good if you’re looking to use your funds within the next 10 to 15 years, but usually not any more than that.
High-Risk Tolerance: Big Risks Lead to Big Potential Gains
Those with a high-risk tolerance tend to be aggressive investors. They’re market-savvy and can remain calm during the dips and swings of the stock market.
A high-risk investor may have an aggressive portfolio of 80 percent stocks and 20 percent bonds (the opposite of the conservative investor). They can see an average return of 9.4 percent, which is around 6.18 percent after inflation.
- A $100,000 investment in an aggressive portfolio would be worth $604,340.40 after 30 years – almost $400,000 more than the conservative investor and $175,000 more than the moderate one.
A high-risk tolerance may be ideal if you’re a younger investor with at least 20 years to grow your wealth. But you may want to adopt a more conservative approach as you near retirement.
What Can Change Your Risk Tolerance?
Your financial planning risk tolerance will likely change as you age and take on more financial responsibilities. Here are some common life events that many of us experience, and suggestions on how you may change your investment strategy with each.
When You Get Married
Combining finances can be tricky, and you and your spouse will likely have different financial goals as a married couple than you did when you were single.
Does one of you have a higher risk tolerance than the other? Do you plan on starting a family or building your dream home in the near future? There’s a good chance you’ll need to change up your investing strategy.
When You Buy A Home
A house is one of the largest purchases you’ll ever make. How you invest your down payment money depends on when you plan to buy. If it’s in three years, you may need to be more conservative than you would if you were buying in 10-plus years.
When you calculate how much you need to save, be sure to include closing and moving costs. These can easily add $10,000 to your savings goals depending on how big the move is.
When You Have a Baby
A bigger family means more responsibility. When you have a baby, you may want to increase your cash reserves, buy a bigger life insurance policy and start a college fund.
When Your Kids are Grown
When your kids are on their own, you may have lower monthly expenses than you did before, yet your income may be at its highest as you near retirement. In this phase of life, focus on maxing out your retirement accounts each year and saving as much as you can each month.
When You’re 10 Years from Retirement
Around age 55 is when many people want to see if they’re on track to reach their retirement goals. If you’re way off the mark, consider what changes you need to make to get on track. This could include picking up a second job, extending your retirement date or downsizing your home.
If you’re on track to hit your goals, keep up the good work! Adjusting your portfolio’s asset allocation may be all you need to do.
How We Can Help
At Align Wealth Partners, we believe your investment strategy should directly align with your financial planning risk tolerance, your goals and your timeline. Remember, the point of investing is to help fund all your goals and dreams (not just accumulate a pile of cash). Whether you need help uncovering your risk tolerance or creating a detailed investment strategy, we’re here to guide you every step of the way.