By: Kristin McCamish Bell, CFA, CFP®
Risk versus reward is one of the key concepts of investing that every investor should understand. The more risk you’re willing to assume with your investments, the higher your potential reward will be. Conversely, the less risk you’re willing to assume, the lower your potential reward will be.
Given its importance to your overall investing strategy, it’s critical to answer the question: What is my level of risk tolerance? Your answer will help you choose investments that are in line with your risk vs. reward expectations.
Note that there are no right or wrong answers to this question. Risk tolerance is highly personal — your level of risk tolerance may be different from your friends’ or relatives’. Instead of comparing yourself with others, you should honestly assess your own risk tolerance so you can build an investment portfolio that reflects it.
The Risk Profile of Investment Options
The riskiness of an investment refers to the volatility of its returns. Different types of investments carry different levels of volatility.
Out of the four broad categories of investments, cash equivalents (such as savings and money market accounts) generally have the lowest volatility and lowest potential returns. The principal value of cash holdings will not decrease; the level of return may vary a little with interest rate policy, but overall, the return is quite low.
Equities (or stocks) are the asset class with the highest risk and the greatest volatility (in public markets), but they also generate the highest potential returns. When you own a share of stock, you are an owner in that company (if a very small owner). The value of a single stock can go to zero if that company goes bankrupt and ceases to operate. However, stockholders benefit from the growth of the company’s earnings over time, and if the company does well, (in theory at least), so should its stockholders. Small cap stocks, international, and emerging markets stocks generally offer higher risk and reward opportunities over large cap U.S. stocks.
Fixed income (or bonds) falls in the middle of the risk vs. reward spectrum. A bond is simply a loan taken out by a company or government entity. Instead of going to a bank, the borrower accesses capital from investors who buy its bonds. In exchange for the capital, the company agrees to pay a set interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value; it also agrees to pay the loan back on the maturity date, ending the loan.
Bond prices can experience some volatility due to the perceived credit risk of the issuer. Credit risk is the risk that a company will not re-pay its bondholders the interest or principal it owes them. The more debt a company or nation carries relative to its profitability, the higher its credit risk. The safest bonds are issued by the U.S. Government; corporate bonds tend to carry more risk but also have a higher return. High-yield (junk) corporate bonds offer the highest risk and reward opportunity in bonds. Changes in credit risk can result in price volatility for a company or government’s bonds.
Bonds also experience some price volatility depending on market interest rates. The coupon rate of a bond is set when the bond is issued, and that coupon never changes for the life of the bond. However, as market interest rates go up or down, the price of that previously issued bond will change. As an example, if you bought a bond with a 3% coupon last year, but interest rates have gone up such that the same company is now issuing bonds at 4%, then that 3% bond is now less valuable, because an investor could go out and buy a similar bond with a higher coupon in the market. The reverse is also true. The price of a bond paying 3% goes up if newly issued bonds are now paying 2%. While the price of a bond will fluctuate between when it is issued and when it matures, if you hold the bond until it matures, you are paid back your initial principal. All types of bonds are generally less volatile than stocks and carry less downside risk. They also generally bring lower returns.
We have a fourth category which we call Alternative Assets. These are varied and may have more equity or fixed income-like risk profiles, or they may be somewhere in between. They include but are not limited to hedge funds, private equity, venture capital, real estate, and commodities. They often are not liquid, which means that you cannot sell them easily like you can a stock or a bond, and they require longer holding periods (sometimes 10+ years). We use them, because they serve to bring diversification to a portfolio and enhance risk-adjusted returns. As your advisors, we are always trying to maximize returns while taking as little risk as possible. Incorporating alternatives helps us do this, because in a year when the stock market is down, your real estate fund could perform nicely, reducing the volatility of your portfolio.
Gauging Your Risk Tolerance Level
Risk tolerance includes both one’s ability and willingness to accept volatility of investment returns. Assessing ability to accept risk has more to do with your timeline (i.e. how long until you need to withdraw the funds) and your level of assets. Assessing willingness to take risk has more to do with how you react emotionally to the fluctuations in the value of your portfolio and can be determined based on how you answer the questions below:
- Do high levels of market volatility make me nervous?
- Am I likely to sell my stocks when the market is down, even when my advisor recommends staying the course?
- Does worrying about suffering losses in my investment portfolio keep me awake at night?
- Do I enjoy the thrill of riding the investing “roller coaster” during times of extreme market volatility?
- Which is more important to me: Protecting my assets against market losses or putting my assets at higher risk to potentially realize greater gains?
- What kind of investment return do I need in my portfolio to achieve my goals of retiring at a certain age with a certain level of assets?
What’s Your Time Horizon?
As we’ve mentioned, understanding your investing time horizon is a very important factor in gauging your level of risk tolerance. In general, the longer your time horizon, the more risk you may be able to assume with your investments. This is because you’ll have more time to make up for potential short-term losses.
If your funds are earmarked for an important short-term goal like buying a home or sending your high school senior to college in the fall, you probably have very little ability to take risk. You may be able to take more risk to meet longer term goals like retirement if it’s 10+ years away.
For example, a young or middle-aged adult investing for retirement has a time horizon of decades before he or she will need to tap the portfolio. In this scenario, the investor can afford to assume a higher level of risk to potentially reap higher long-term returns.
However, a couple in their late 50s or early 60s investing for retirement has a much shorter time horizon before they will need to tap their portfolio. This couple might want to dial back their risk to protect principal in case the market suffers a sharp drop when they’re ready to retire.
This couple may not want to eliminate risk completely by going ultra conservative because they will still need to generate returns in their portfolio to support a retirement that could last 20 to 30 years or longer, but they still might want to reallocate their assets to reflect a less aggressive and more conservative mix than when they were younger.
What’s Your Risk Capacity?
Risk capacity, unlike tolerance, is the amount of risk that the investor must take in order to reach their financial goals. The rate of return necessary to reach these goals can be estimated by examining time frames and income requirements. Then, the rate of return information can be used to help the investor decide upon the types of investments to engage in and the level of risk to take on.
Risk capacity acts as a balance to the factors that determine an investor’s risk tolerance. Your risk capacity includes your time horizon and emotional fortitude to endure volatility, as well as the rate of return and additional savings needed to meet future goals.
If you set certain goals to live a comfortable lifestyle in retirement, but the fluctuating value of the portfolio that will supposedly get you there is stressing you out, then your capacity is lower than it would otherwise be. You might need to adjust your expectations for what is attainable and be more conservative in your spending today. On the other hand, if you received an inheritance or other financial windfall that’s not earmarked for any particular short-term purpose, you probably have a little more risk capacity with these funds to assume more risk.
How A Financial Advisor Can Help
A Simon Quick advisor can help you determine your level of risk tolerance and construct an investment portfolio with the kinds of securities that reflect it. To learn more, call us at (973) 525-1000 or send an email to email@example.com.
Kristin McCamish Bell
Ms. Bell joined Simon Quick in 2018, extending the firm’s reach to the Southeast by opening an office in Chattanooga, TN. As Director of the Southeast and Client Advisor, Kristin counsels and advises high net worth individuals and families on wealth management and financial planning to help them achieve their financial goals. She also advises endowments and foundations on developing an investment policy statement, asset allocation, and portfolio implementation. Kristin completed the Chartered Financial Analyst program and received the CFA designation in 2004. She is a member of the CFA Institute, the CFA Society East Tennessee, as well as the Chattanooga Estate Planning Counsel. In November of 2019, Ms. Bell became a Certified Financial Planner. Kristin holds a B.S. in Psychology from Wheaton College, where she was also captain of the Women’s Tennis Team. She has served on a variety of non-profit boards but currently serves on the Board of Directors and Development and Finance Committees of the Children’s Advocacy Center of Hamilton County. Learn more about Kristin on LinkedIn.
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