What does investment risk mean to you, either for an individual security like a stock, a bond or a mutual fund, or for your entire portfolio?
Measuring Investment Risk
If you’re like most people, you’ll probably refer to the investment or portfolio’s standard deviation (or “SD”). SD measures how much the investment’s returns vary around its average. An investment with highly volatile returns over time will have a high SD, while an investment with very stable, unvarying returns will have a low SD. Stocks tend to have higher returns and higher SDs of their returns, while bonds tend to have lower returns and lower SDs of their returns. So, stocks are “high risk, high return” and bond are “low risk, low return”, the thinking goes.
But there’s another, arguably more important, way to think about investing risk. And that’s the possibility that your portfolio returns will be too low to allow you to save enough to fund all of your goals – like retirement, travel and vacations, charitable giving, college for kids or grandkids, and so on. You can think of this as the danger of taking “too little portfolio risk”.
How Much Risk is Too Much?
How much is “enough” portfolio risk? To answer that question, you really need a robust financial plan.
If built correctly, your plan will include a lot of assumptions, including your income need in retirement, the other spending goals we referenced above, your life expectancy, an estimate for inflation – which erodes your money’s purchasing power over time – and an important assumption for the expected return on your investments. Of course, it’s important that the assumption for investment returns is realistic.
It’s also important that you’re comfortable with the risk associated with your investment mix. Why? Because if your portfolio’s investment mix – also referred to as its asset allocation – is too aggressive for you, you may be inclined to “abandon ship” when the stock market goes through one of its periodic corrections. And, generally speaking, one of the worst things you can do for your long-term financial success is panic and sell investments after they’ve fallen in value.
These corrections, or bear markets, can cause the stock market to drop by 50% or more from “peak to trough”. How would you feel if your portfolio lost half its value in a matter of weeks? Your answer may give you an indication of your sensitivity to investment risk.
Measuring Your Risk Tolerance
There are a variety of ways measure tolerance and capacity for investment-related risk. At Springwater, we’re currently using a robust tool from FinaMetrica. FinaMetrica is widely acknowledged to be the worldwide leader in scientifically-valid “risk profiling” – a process for finding an investor’s optimal level of investment risk by balancing the risk required, risk capacity and individual risk tolerance.
If there’s a mismatch between the risk required for your plan to succeed and your capacity and tolerance for investment risk, you’ll need to explore ways to modify your plan so that you’re able to achieve your goals with an investment mix that’s comfortable for you. That might involve reducing your planned spending in retirement, saving more, or some combination of the two.
A financial advisor can help you measure your investment risk tolerance, and then determine the right investment mix for your plan.
Looking for Guidance?
If you need help with planning and investing, consider working with a Certified Financial Planner™ (CFP®), Certified Public Accountant (CPA) or a Chartered Financial Consultant® (ChFC®) or an RICP (Retirement Income Certified Professional®). Advisors who hold these designations have met rigorous educational, experience and ethics requirements.
If you’re looking for help with planning and investing for retirement, contact us today to see how our team at Springwater Wealth can help you.