When it comes to being a successful investor, knowing your risk tolerance is key.
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Whether you are a risk-taker, more conservative or a mix of both, knowing just how much exposure you are comfortable with is important to avoid becoming beholden to the gyrations of Wall Street.
“A lot of people don’t know their risk tolerance at all,” says Jennifer Landon of Journey Financial Services in Idaho Falls. “When the market is going up everyone is thrilled. When the market starts to drop people lose their moxy.”
An easy formula to find risk tolerance that has been around for a long time is to subtract your age from 100 to figure out your stock and bond weightings. But experts say that is a too-simplistic tactic since it doesn’t take into account your long-term goals, current financial situation or your expectations.
“For us risk tolerance has two pieces,” says Chris Cook, founder and president of Zero Commission Portfolios in Dayton, Ohio. “Your time horizon and, more importantly, your risk personality.”
Your time horizon is the simple aspect to fig ure out: The older you get, the less time you have to recover from a big drop in the stock market, (like what happened in 2008) which means you’ll want to be more conservative. The younger you are, the longer you have to recover from a big hit so it’s OK to be more aggressive.
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Your risk personality is more challenging to figure out. “It’s worth the time to go through some self-reflection to figure out what kind of person you are,” says Cook. “Are you the guy that loves to walk on the high wire or do you want both feet on the ground at all times?”
You’re financial goals and current financial situation also have to be considered when determining your investments’ risk exposure.
Ask yourself what happens if you don’t get your desired rate of return, if your taxes increase, or worse, you need the money earlier than planned. “If you really need the money for income purposes or to feel secure then you should be more conservative,” says Landon.
When determining your risk tolerance, Jonathan Smith, co-founder and CEO of DT Investment Partners, recommends imagining losing 50% of your investments: what would that mean? A drastic change in lifestyle? Or will your life carry on almost as normal? If it’s the later, you most likely can handle more risk.
“Review the past 20 years and find the worst return year for the strategy you are contemplating and see if you could you handle it mentally,” says Smith. “You have to take a common sense look at the worst possible year to get a sense of what your maximum downside most likely could be. If someone is totally shocked by being down 25%, then he or she shouldn’t be 60 equities 40% bonds.”
A common mistake among retail investors is setting unrealistic expectations over how much they can make in the stock markets.
For instance, many people would welcome volatility if they knew a 9% or 10% return would result, but experts say that is not a realistic expectation. “Most mutual funds won’t perform as well as the market,” says Landon, noting that investment fees will also reduce the return on the investments. “A lot of people don’t consider the fees and the tax effect,” she says. “Their real rate of return ends up being 3% to 4% and they are taking on a tremendous amount of risk to get that.”