Your Attitude Toward Risk Helps Me Understand How To Manage Your Money
While we can do a great deal to mitigate risk, we cannot eliminate it. In any investment plan, it is important to understand both the types and the amount of risk you are taking and to be sure that you are comfortable with these. This understanding will greatly increase your ability to adhere to your long-term investment plan and increase your chances of achieving your financial goals.
The right level of risk for you depends on both your personal preferences and your situation. We break the risk equation into the following four parts:
1. Risk Tolerance: Your Response to Market Fluctuations
Over the course of your investment life, the value of your portfolio will rise and fall. While we would always rather see our portfolio value rise, a prudent investor knows that any investment will have some periods in which the value will fall. Equity markets, in particular, are very volatile, and investors must expect that there will be regular periods of rising prices and regular periods of falling prices.
Your risk tolerance describes your level of comfort in waiting through the downturns. If the risk you take is within your risk tolerance, then you will be able to maintain your investment strategy through both strong markets and weak ones, giving you the best chance of investment success.
2. Risk Aversion: Your Vulnerability to Losses
Designing an appropriate investment strategy requires understanding and weighing factors that can be in conflict. Your tolerance for risk may be high, but as a prudent investor, you should consider your ability to withstand financial losses. Because market downturns are unpredictable, you need to assess the real economic harm you might face if your portfolio seriously declined in value. If your portfolio failed to provide the returns you had planned for, would you need to adjust your goals?
3. Risk Avoidance: Your Need to Take Risk
Most investors would not choose to take more risk than is necessary. While this is a simple statement, investors often fail to build this concept into their investment planning. Your need to take risk is directly tied to your rate-of-return objective.
If you need your portfolio to grow more quickly over your time horizon, you will want a higher rate of return. An increase in your rate-of-return objective, however, will generally mean taking more risk. If your return objective is higher than your risk tolerance (willingness to take risk) or your risk aversion (your vulnerability to losses), then you must adjust one or more of these parameters. This could mean, for example, retiring later and possibly subjecting yourself to the discomfort of greater risk or increasing your savings.
On the other hand, if your rate-of-return objective can be lowered because your assets can support your goals with less growth, then your need to take risk is reduced and your portfolio should be allocated accordingly. As your portfolio grows over time, your need to take risk should be reassessed and your investment strategy adjusted accordingly.
4. Your Tolerance for Tracking Error: Your Ability to Have Your Portfolio Look Different from Popular Indices
Many investors are more comfortable when they know they are doing as well, or as poorly, as most other investors. A portfolio that tracks the returns of a popular index such as the S&P 500 can provide that comfort, despite the fact that it may not provide the risk management or higher returns that may be available from an effectively diversified portfolio.
Tracking erroris the amount by which the performance of a portfolio differs from that of major market indices. You should understand your personal tolerance for the tracking error that can result from a portfolio that purposely diversifies away from popular indices in order to decrease volatility and increase expected returns.
Bear in mind that tracking error can be present over lengthy periods. If, for example, your portfolio is weighted heavily toward value asset classes because of the expected higher return over time, it will often look quite different from the S&P 500 index, which is composed primarily of growth stocks. The difference can be either positive or negative, and may be present over many years.
After having read this explanation, is there anything you would want me to know about managing your money and the risk you want to take? Please contact me if this article opened your eyes to the risk level you would like to take.