Risk is an inherent part of investing. Greater risk often brings greater reward, but that doesn’t mean investors are eager to gamble.
Despite experiencing the second-longest bull market in history, many investors remain reluctant to invest in stocks. A 2017 Bankrate survey found that real estate was the top investment of choice for 28 percent of investors, with cash coming in a close second. Just 17 percent of investors said they’d invest in stocks for the long term.
Avoiding stocks, and risk in general, may insulate your portfolio from seismic market shifts, but you may sacrifice growth in exchange. David A. Schneider, principal of New York-based Schneider Wealth Strategies, says investors often get risk all wrong. “Investing is about embracing risk, not avoiding it,” he says, and trying to eliminate it from your investments is impossible. Each time you reduce risk in one area, you increase exposure to a different risk.
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He points to investors who trade out of stocks and into cash as an example. They may believe they’re avoiding risk, but they’re really trading market risk for purchasing-power risk, since the return on cash is low relative to inflation. A similar scenario occurs when investors move out of intermediate- or long-term bonds into short-term bonds to protect themselves from interest rate risk. In doing so, “they’ve increased reinvestment risk, purchasing-power risk and possibly credit risk, depending on what they buy.”
Aaron Klein, CEO of Riskalyze, a portfolio analysis and risk alignment platform, says investors are better served when the first step of an investing strategy is determining risk. That way, investors can push past their fears and make the right decisions with their investments. If you’ve been sidestepping risk, facing it head on could help strengthen your portfolio.
Risk tolerance and risk capacity aren’t the same thing. These two concepts may seem similar but can have vastly different implications for your investing strategy. “Knowing the difference between risk tolerance and risk capacity can make a huge difference in how you structure your portfolio,” says Christy Smith, founder and investment advisor representative at The Presley Group in Denham Springs, Louisiana.
Risk tolerance refers to the amount of risk — or losses — you’re willing to withstand in your investments. Your risk tolerance will determine how you handle the stock market’s ups and downs and whether you hold on during big drops or sell at the worst possible time out of fear. Risk capacity, however, means how much risk you need to take to reach your investment goals. Your risk capacity can enable you to maintain your position during a market drop due to the strength of your overall financial plan. Both types of risk assessments are important, particularly when creating your retirement plan, Smith says. “You need to evaluate how much you’re willing to lose, along with how much risk you can take before it affects your lifestyle.”
Your risk tolerance and risk capacity can work together to help you keep emotions out of investment decisions. Investors must have the mental capacity to hold on, as well as the physical capacity, in the sense that they have sufficient investments and income to sustain a prolonged market downswing, says Lou Cannataro, partner at Cannataro Park Avenue Financial in New York.
You’ll need the right metrics. A simple way to measure risk capacity is by looking at factors like liquidity, time horizon, net worth and current income, says Greg Oray, president and investment advisor representative at Oray King Wealth Advisors in Troy, Michigan. “The point is to measure the impact losses will have on your wallet and lifestyle.”
[See: 9 Investing Myths That People Still Believe.]
Oray says the same factors can also be used to measure risk tolerance, but the emphasis shifts more heavily to your emotional capacity for smart decision-making. Someone who’s living on investment savings, for example, is more susceptible to the negative impact that high-risk investments could have on their lifestyle.
It’s also a mistake to make assumptions about an investor’s risk tolerance based on the person’s age, Klein says. Labeling younger investors as aggressive and older investors as conservative, for example, doesn’t always provide an accurate description of an investor’s risk tolerance.
A risk tolerance questionnaire can help fill in the gaps, but even that can fall short of creating an accurate picture of how much risk you’re comfortable taking. When in doubt, it’s better to keep a short-term perspective for gauging risk tolerance, Smith says. With her clients, she uses a six-month window to measure how their risk tolerance might be affected if the market goes up or down. Still, investors can’t neglect the longer view, as risk tolerance and risk capacity should also reflect a person’s life expectancy so that investment returns will keep pace with longevity.
Work with risk, not against it. Your investment plan should be based on a set of assumptions about general market conditions, inflation, taxes and similar metrics. As you create your plan, you should test those assumptions against what-if scenarios to set realistic expectations. For example, the compounding effects of inflation or expected rates of return could present a greater risk to younger investors while market risk may be more detrimental to a late-stage retiree. “Being able to quantify your risk preferences amidst various plan assumptions can help to balance potential risk and reward,” Klein says.
Comparing the risk-adjusted returns of investments can help you determine if you’re being rewarded appropriately for taking on a certain level of risk, says Michael Sheldon, executive director and chief investment officer for RDM Financial Group at HighTower in Westport, Connecticut. A risk-adjusted return is the return of a specific investment divided by the standard deviation, which is a measure of historical volatility, and should be compared against a benchmark index.
[See: 10 ETFs to Buy for High Growth.]
Designing a portfolio consistent with your risk tolerance depends on how much of a decline in wealth you can tolerate in pursuit of higher long-term returns, Schneider says. Once you’ve determined that, you can create an asset mix that includes risk while reducing the risk of exceeding your maximum downside threshold. “Ultimately, investing is really about deciding which risks to take and how to balance them.”
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How to Say Yes to Investing Risk originally appeared on usnews.com
