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Is There Too Much Risk In Your Portfolio?
Risk is not just the game of world domination. When it comes to your money, taking on too much risk can mean not reaching your goals. While there are many elements of investing we can’t control, such as industry or political events that cause markets to go haywire, there are certain steps we can take to reduce risk and our exposure to loss.
What Is Investment Risk?
Risk is fundamental to investing. Even “investing” by hiding cash under your mattress involves the risk of losing your purchasing power to inflation. Risk makes markets, and without risk there is no return. Markets are driven by risk-seeking investors who aim to be compensated for the risk that they take in the form of investment return.
Some risks are avoidable while others are not. Avoidable risks include a lack of diversification, where a single company-specific event can have a massively detrimental impact on your savings. For example, you may hold too much of your company’s stock in your 401(k) plan. Or you may be far overinvested in a single sector of the economy, instead of being more globally diversified.
On the other hand, unavoidable risks are those that occur because our world is ever-changing, volatile, and we can’t predict everything. As much as we believe in our own investment abilities, the world is uncertain and many risks are simply out of our control.
Risk is also personal. Your risk tolerance is based on your experience, stage of life, and personality, so it’s not going to look the same as any other investor’s.
How Much Risk Do I Actually Need To Take?
To address avoidable risks in your portfolio, start out with a simple question: “How much risk am I willing to take to afford the things I want?”
If you are planning for retirement, or funding a specific goal such as a child’s education, you can calculate the expected cost of your goals. Then work backwards to find the return and subsequent risk required from your portfolio to match that future expense. You may even find that you are not taking enough risk; perhaps you’re on a path where you won’t be saving enough or growing your portfolio enough to live the lifestyle you’d hoped for.
Knowing how much risk you are willing to take, you can design a portfolio that is aligned to your risk tolerance and goals. But sticking with that portfolio to reap the benefits over the long term is another animal entirely.
The Cycle of Emotions
The cycle of investment emotions, shown below, has driven some people to financial ruin. As Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.” What most people do instead is shown below:
When markets are at euphoric highs it is only natural for greed to kick into high gear, making us feel like we want to take even more risk to really make a killing. But this kind of emotional investing can lead to disaster.
Conversely, when markets are at their lows, fear keeps us from taking on new risk even when investment opportunity is at its highest. In fact, the fear of loss is so powerful that individuals have been shown to feel the pain of loss more than twice as intensely as any joy felt from an equally sized gain (see the Nobel Prize winning work of Daniel Kahneman in his book Thinking, Fast and Slow). Buy low, sell high is certainly much easier said than done.
Avoiding The Big Mistake
The cycle of emotions has a very real impact your investment success, but its effects can be mitigated. The question we need to answer is: “how far can my portfolio fall before I capitulate and make an emotionally-charged poor decision?” This is the scenario we want to avoid, and it tells us how much risk you can handle in your portfolio.
Once you understand your personal appetite for risk, you can set your investment expectations accordingly. This will minimize the situations where you feel the pain of loss forcing your hand into a poor investment decision to sell and abandon your long-term plan. You’ll be less likely to constantly struggle with the feeling that you are missing out when things are good and worrying about loss when things are bad.
Putting It All Together
It is entirely possible for you to understand 1.) how much risk you need to take to fund your goals and 2.) how much risk you can emotionally handle. The next step is to find a balance between these needs and align the risks in your portfolio accordingly. To go one step further, write it down as a first commitment toward putting a plan in place for your portfolio and your goals.
We offer an online risk tool that can help you identify your risk tolerance, review your current investments, and align your portfolio to match. You can take the first step today by using our online quiz to discover your personal tolerance for risk and set your investments accordingly. This 5-minute exercise is an easy first step in learning if there is in fact too much risk in your portfolio.
To determine the right amount of risk to fund your financial goals, we recommend a no-obligation conversation and review your risk number and next steps to take. If you have any questions, don’t hesitate to call us at (844) 377-4963 or email email@example.com. You can also book an appointment online here.