There are fewer things in personal finance more important than taking on the proper amount of risk, and fewer tools more ineffective at determining the proper amount of risk than a traditional risk tolerance profile.
If you’re not familiar with what I’m talking about, it’s a boilerplate legal document found in most financial account opening paperwork.
From my perspective, it’s designed more for the financial company to cover it’s butt than to help the investor.
To be fair, it’s not easy to talk about and educate investors about risk.
Basic rules of thumb tell us a younger person should be more aggressive because they have more time to invest. And an older person should be more conservative because they have less time. The thinking is based on the ability of an investor to withstand a negative event in the stock market.
But that doesn’t necessarily make sense.
If you’re 25, but actually a conservative investor, you’ll develop an ulcer worrying about your investments. Not good.
Alternatively, if you plan to stop working at 65, but intend to live to 95, it may not make sense for you to be ultra-conservative with your investments.
There are so many more variables to take into consideration than simply age and time horizon.
That’s what I’ll help you do here; figure out the right amount of risk for you and how to actually apply it in your life.
Here’s what we’ll cover:
- Risk tolerance
- Investor profile
- Asset allocation
- Asset classes/types
- Time horizon
- Asset location
- Real life application
Let’s get started
Risk is the likelihood the investment you make gets the return you expect. For example, if you’re expecting a 5% rate of return, what’s the likelihood of getting it?
Saving is your ability to have money left over after you’ve paid all your bills and made all your expenditures. Savings can be grown through investing, which requires that the money be put at risk.
The main difference between investing and speculating is the amount of risk. Speculation can be thought of like gambling, whereas investing is based on research and the known fundamentals of the asset you’re putting money towards.
Risk tolerance is the amount of risk you’re willing to accept. It’s your investing comfort level.
Informed by your risk tolerance, your investor profile seeks to help you to determine your asset allocation.
If you’re okay with risk, you’ll have a more aggressive investor profile.
If you don’t like a lot of risk, you’ll have a more conservative investor profile.
There are five traditional profiles:
Conservative, Moderate Conservative, Moderate, Moderate Aggressive and Aggressive.
Your profile can remain static throughout your life, or it can certainly change. It can adjust as you get older, and/or it can adjust as you learn more about investing and have more experience.
Simply getting to know more about what kind of investor you are is a really important starting point.
Your profile will help you to determine your asset allocation.
Asset allocation is the term used to describe the types of investments (Asset classes) you own. Oftentimes, an asset allocation will be created based on the answers to a risk tolerance profile.
A common asset allocation is a 60/40 allocation, meaning 60% of your investable assets are equities (stocks) and 40% are fixed income (bonds).
Here’s another example:
20% Real estate
It’s simply the term used to describe your mix of assets/investments.
Asset classes are groupings of similar investments.
- Equities (stocks, stock mutual funds, stock ETFs)
- Fixed income (bonds, bond mutual funds, bond ETFs)
- Cash and cash equivalents (checking, savings, money market accounts)
- Real estate (primary residence, investment real estate)
- Commodities (precious metals, oil, etc)
- Currencies (traditional)
- Private businesses
- Crypto assets (cryptocurrency, NFTs)
Time horizon deals with when you intend to access or use a particular investment.
We often think about time horizon in terms of short, mid and long-term.
A short-term time horizon is one to three years. Common priorities are an emergency fund, annual vacation fund, and daily living expenses.
Mid-term is three to 10 years. Common priorities are the down payment on a home and a child’s education.
Long-term is 10+ years. The most common priority is retirement planning.
Next, we need to determine the best place (account type) to own the investment.
Common places include bank accounts, taxable brokerage accounts, college savings plans, and qualified plans (IRAs, 401(k)s and pension plans).
Each account type has features and benefits which need to be considered.
Real life application
How do I know what kind of investor I am and what my risk tolerance is? You’ll need to complete one of those risk tolerance profiles I alluded to in the intro.
You can find and download our Risk Profile worksheet.
From there, here’s a framework to help you make decisions:
- The starting point is determining your risk profile
- Figure out your financial goals
- Determine the time horizon for achieving your goals
- Decide on the right investment
- Finally, you’ll decide what type of account is appropriate
Here is an example:
I’m a Moderate Aggressive investor who is 35 years old. I want to save for the down payment on a house which I intend to purchase in two years. I also want to save for my child’s education which will begin in 12 years. Finally, I want to save for my retirement which will be in 30 years.
Goal #1 Down payment on home
- Two year time horizon = short-term
- Asset selection = cash
- Asset location = savings account
Goal #2 Child’s education
- 12 year time horizon = mid-term
- Asset selection = Equities (more specifically stock mutual funds or stock ETFs)
- Asset location = Taxable brokerage account or College savings account
Goal #3 Retirement
- 30 year time horizon = long-term
- Asset selection= Equities (more specifically stock mutual funds or stock ETFs, or Target date fund)
- Asset location = Qualified plan (IRA or 401(k))
There are a lot of moving parts when it comes to making investment decisions. I encourage you to take the process one step at a time.
It’s also important to think about your financial situation in total when figuring out the right asset allocation for you.
Too often, we think about our financial matters in silos or vacuums.
For example, when we’re trying to decide which investments to choose inside of our 401(k), we don’t think about the investments we already have inside our brokerage accounts.
It’s wise to take everything into account when thinking about and making your investing decisions.
If you’re ready to take control of your financial life, check out our DIY Financial Plan course.
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