Risk and Allocation Basics
Investing in the markets is a bit of a double-edged sword. The higher the potential for gain, the greater the risk becomes. It works the other way too – the less risk you take on, the fewer gains you’re likely to have. Striking the right balance is essential for building the ideal portfolio. Taking on more risk than you’re able to handle is just as bad as taking on too little and ending up with a smaller investment than you planned for.
Some advisers place investors in one of two risk categories – aggressive and conservative. But in reality, there are many shades of risk tolerance that need to accounted for. Knowing what your own risk tolerance is and how to build a portfolio that meets those expectations is critical to long term successful investing.
Gauging your risk tolerance
One of the first things to consider when assessing your risk tolerance is how far away your investment time horizon is. The further away it is, the more risk you can take on since there’s more time to recoup from economic pullbacks and poor investment choices.
One simple way to determine what allocation you need is to take your age and subtract from 100. For example, if you’re 30 years old, then you would put 70 percent of your portfolio into riskier assets, like stocks, and 30 percent into more conservative investments, like bonds.
But that doesn’t take into account personal risk preferences. If you’re more aggressive, you can subtract from a higher number like 115 and then see what allocation you end up with. One of the most common allocations you’ll find in mixed mutual funds is a 60 – 40 split of equities and bonds.
There are plenty of easy online quizzes you can take to determine your personal risk preference. But you can probably figure out yourself by asking one question – how would you feel if your portfolio dropped 10 percent in a single day? If you’re the kind of person who would check their account multiple times in a trading day to see if you’ve lost money, you’re probably risk-adverse and need a more conservative portfolio.
Currently, advisers are recommending that investors lean more on the risk side than conservative. Even for those nearing retirement, keeping more in stocks than bonds will help keep your portfolio growing at a reasonable rate relative to withdraws. For those approaching, or in, retirement, the trick of subtracting from 100 doesn’t really work. You would end up with a heavily conservative portfolio and with interest rates as low as they are, the odds of growth in excess of withdraws is very low.
Proper allocation is not a reason to ignore due diligence. Just because you design a portfolio with the ideal mix of stocks and bonds doesn’t mean that it’s diversified or that the assets chosen really fit your investment objective. Make sure you make investment choices that align with your risk tolerance before committing yourself.