Investors naturally tend to focus on the return they expect to receive from a financial strategy or investment. But that single-mindedness can be a huge mistake because it ignores the impact of risk.
Too much risk can lead to what Arlen Olberding, owner of Guidepost Financial Planning in Fort Collins, Colo., describes as "inappropriate responses," such as buying too aggressively when the stock market is overheated or selling in a panic when the stock market takes a dive.
"Make sure you're aware of what you're buying, how much risk you're taking and what you're comfortable with," Olberding says.
Here's why risk matters, how to determine your own investing risk tolerance and how to mitigate it.
When is your risk level too high?
There are two signs that your risk level is not appropriate for you as an investor. The first sign is that you are not able to talk openly with your spouse about the risks you're taking. And second, you're not able to sleep soundly at night because you're worried about how much money you might lose, Olberding says.
Beyond those clear danger signals, it's not easy to decide how much risk you can handle, says Ronit Rogoszinski, a wealth adviser at Arch Financial Group in Garden City, N.Y. One reason that's the case is that you won't truly know how well or badly you'll react until you actually experience an adverse event.
One way to visualize and try to measure your own risk tolerance is to "start putting numbers on a piece of paper," Rogoszinski says. Suppose you have $1 million to invest. Consider how you'd feel if you receive a brokerage statement that shows your funds have increased to $1.2 million or shrunk to $800,000. Your reaction might give you some clues as to your risk comfort level.
More risk means potentially larger rewards but also potentially a bigger downside. The starting point for the discussion of how much risk you can tolerate isn't the upside you want, but the downside you don't want.
"What do you want to avoid?" Rogoszinski asks. "Are you OK with a negative 5% return? A negative 10% return? If you're telling me, 'I will have a heart attack if I lose 15%,' we then need to talk about what you can expect on the upside," she says.
Risk is unavoidable
Given the challenges, avoidance of risk might look like a safer strategy. But, alas, that's not the case. Andy Tilp, principal at Trillium Valley Financial Planning in Sherwood, Ore., says investment risk -- the ups and downs of the stock market -- isn't the only type. In fact, there are numerous risks, including risks involving interest rates, currencies and inflation, and it's simply not possible to avoid all of them.
"For the person who says, 'I don't want any risk at all, so I am going to put my money in an envelope in my desk drawer, and then I'll know it's there,' there is inflation risk. That money loses buying power over time," Tilp says.
Rogoszinski suggests a better approach. Focus on the allocation of investments with different levels of risk, and make adjustments as you age.
The traditional thinking is that younger people can take more risks since they'll have time to recover any losses, whereas older people don't have that cushion. Rogoszinski says such thinking "still makes sense," though some investment risk might be appropriate at any age.
"Even if you're older, it's very important to know what you are investing in. You still need equities in your portfolio," Rogoszinski says. "The question then becomes, 'What's the allocation to it? Is it 80% or is it 30%?'"
Diversification mitigates risk
A separate challenge is figuring out how risky various financial strategies are, says Alan Moore, a Certified Financial Planner professional at Serenity Financial Consulting in Milwaukee.
"It's impossible to calculate projected risk," Moore says. "We can say that historically stocks have been this volatile and bonds have been this volatile, and we can calculate that, but how relevant is it really? It's about as relevant as looking at last year's returns. Any time we base (an assumption) on historical data, we know we're wrong. We may be better or worse off than our assumption, but we know it's just an assumption -- a guess."
So how can anyone manage risk?
The answer is diversification, the classic strategy of "don't put all your eggs in one basket," Moore says. Moore says some of his clients' portfolios hold as many as 18,000 different companies through multiple mutual funds. That way, if one company goes bankrupt, it doesn't have much effect on the entire portfolio.
"Diversification is the only real way I know to manage risk," he says. "Buy stocks in as many countries and companies as you possibly can, and do the same with bonds. Spread that risk out."
Copyright 2013, Bankrate Inc.