Are You Overestimating How Much Risk You Can Stomach?
When investors ask themselves how much risk they’re comfortable taking, they’re probably not answering the question in the right way … and it could cost them.
While it often does not get enough attention from many financial advisers, managing market risk is one of the most important tasks every individual will face. We don’t like to admit it, but individuals, even those who work with financial advisers, are often exposed to more risk than they realize.
The typical investor tends to focus on how much money she or he can make in the market instead of thinking about risk, “reaching for yield” without considering how much additional risk they are accepting. Because of this tendency, market risk is something to be mindful of as you plan for retirement and think about how to build your portfolio.
Think in Terms of Dollar Signs
When you focus on risk management, one good way to approach it is by thinking about your portfolio in terms of actual dollars. Instead of thinking about your portfolio in terms of percentages, it’s often better to think about the actual monetary amount of your various assets. For example, it’s easy to say, “I’m comfortable with losing 10% of my portfolio.” But that kind of abstraction can get in the way of effective risk management by masking the true impact of market fluctuations.
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Instead of thinking in terms of percentages, let’s define how much you are willing to lose in an actual dollar amount. This makes it far more real. How many of us are willing to say, “I’m comfortable with losing $50,000?” Certainly, far fewer of us than will say “I’m comfortable with losing 10%.”
Thinking about your risk tolerance in terms of actual dollars can help offer far more clarity and guidance as you start managing risk.
Break Your Portfolio Into 2 Parts
It’s also helpful to think of your investment portfolio as having two sides, especially when planning for retirement. On one side are the investments exposed to market risk, while the other side contains financial vehicles with no market exposure. As you craft your portfolio and prepare for retirement, it is wise to find a combination of financial vehicles on both sides.
On the market investments side are stocks, mutual funds, variable annuities, bonds, commodities, currencies, 401(k)s and similar investments. These investments have the potential to grow but also come with the risks associated with the market. On the other side (no market exposure), are specially constructed life insurance policies with tax-exempt income, fixed and fixed index annuities with lifetime income riders and long-term-care riders, and, in some states such as California, life settlements, all of which have no market risk.
Determine Your Top Risk Factors
One of the most important things you can do as you build your portfolio is determine how much you can risk in the market based on your age, health, income, risk tolerance and other variables. You should also ask yourself how much of your assets you should have on the market side and how much you should have on the non-market side. There are no right or wrong answers, but you need to ask yourself these questions as you plan for your retirement.
Of course, every individual has his or her own needs and goals. On the whole, younger individuals can usually afford more risk, while those at or near retirement simply can’t afford a major loss if the market has downturn like what we saw in 2008.
We all have different needs as we try to figure out how much of our portfolios should be on the market investments side and how much should be on the non-market side. Fortunately, there are qualified and experienced advisers and software programs that can help you figure out an amount of market risk that you are comfortable with.
Revisit Your Risk Assessment Now and Then
Another thing to keep in mind is that the markets and our needs are always changing. No bull or bear market lasts forever. Our risk tolerance continues to change, and we should modify our portfolios accordingly. It’s a good idea to re-evaluate your risk tolerance and how much you want on each side at least once a year as the market and your own needs continue to change.
A trusted adviser can help you find your comfort zone when it comes to market risk and help you plan accordingly. Too many advisers and individuals consistently ignore risk, but managing risk is an important (ongoing) decision.
Find out how much risk you are comfortable taking in your assets, and craft your portfolio accordingly.
David Braun is an Investment Adviser Representative and insurance professional at David Braun Financial & Insurance Services Inc., based in Upland, Calif. CA#0678292
Kevin Derby contributed to this article.
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