In investing, risk tolerance is a phrase used to describe how much an individual is willing to see their account fluctuate, due to the amount of exposure one has in the stock market.
As most people know, the stock market is unpredictable and has many ups and downs. Many people react to those ups and downs differently. Therefore, risk tolerance is unique to each person.
There is a sliding scale to risk tolerance. One can invest 100% in stocks/mutual funds/Exchange Traded Funds (ETFs), which is the most aggressive form of investing. Next, someone could invest their money in 100% bonds, which is the most conservative form of investing. And lastly, they could also do a moderate approach where there are some stocks and some bonds; this mix and matching could be somewhat aggressive or somewhat conservative, depending on the allocation between stocks, bonds, and held cash.
Conservative investing is for those who have the lowest risk tolerance possible. These are the people who are most reluctant to invest at all and would most likely choose to have their money in their mattress. Money is very emotional for this group, and seeing any drop in the original investment amount is a calamity.
Luckily, if you feel as though that is you, there are options out there.
When risk tolerance is non-existent, or no risk tolerance, then there are a couple of options. The first is an all-bond portfolio. A company, a municipality, a state, or even the federal government, will agree to pay you back your money plus some extra after a certain amount of time. This grows your account at a slow but reliable pace, although bonds do still fluctuate in value. The other way is to keep it invested in a money market account, such as the Schwab Money Market fund.
Money Markets are extremely safe investments; however, when something is safe, the investor loses out on higher potential annualized returns.
Middle of the road
Investing moderately is another tactic. Many people want some portions of their money safer, and other portions with the potential for higher annualized returns. The level at which people want that depends entirely on their risk tolerance.
We have numerous clients all over that sliding scale. When describing this allocation, we say things like 90/10, 50/50, 80/20, etc. The first number represents the percentage of held stock/mutual funds/ETFs in a portfolio, and the second number represents the number of held bonds/money market funds in a portfolio. When it comes to mixing and matching in a moderate portfolio, it is important to understand this concept.
For someone with a 90/10 portfolio, we would still generally consider their risk tolerance to be aggressive. As that first number goes to 80, 70, or even 60/40, that is more moderately aggressive, because there are more stocks than bonds. As soon as the number is even, a 50/50 portfolio, is perfectly moderate. As bonds take up more space than stocks in a portfolio, we go to moderately conservative, all the way back down to conservative.
Mixing and matching these allocations is a very popular practice in investing for a couple of reasons. First, it keeps a portion of your money safer and always potentially increasing. And secondly, it usually causes greater diversification in a portfolio.
Aggressive investing is a fantastic way to invest. This is for people who see the stock market as it is and understands it has ups and downs, and in the long run, are exposed to the highest potential annual returns than anyone else. The stock market since its inception has produced around 9-10% annualized returns on average.
For those with a high-risk tolerance, being in a heavily-weighted stock/mutual fund/ETF portfolio is the perfect thing. While invested, these people will see account drops of 25-35% in some years, while also reaping the benefits of riding that rollercoaster all the way back to the top with 25-35% gains in some years. Again, this isn’t typical, but as long as your risk appetite logically understands that this could happen, in the long run, an aggressive investor will always have higher returns in their portfolio. Again, the average return of a stock market portfolio is 9-10% each year compounded.
Having an advisor walking you through the emotion and logic of the stock market, and how your money could potentially be invested is a very important first step when determining your risk tolerance. Everyone is different, and there is something out there that meets your needs emotionally and logically.
The power of speaking with your advisor
As overwhelming as the stock market, timing, capital losses, and more can become, always feel free to use an advisor you know to just ask questions. It is our passion to help people understand these topics.
When it comes to the life work of our clients and prospects, no decision is ever taken lightly. No account value is disregarded because all concerns and questions hold such a heavy weight in a time like this.
We hope you’ve learned a great deal from this article, and more importantly, reduced some stress from your life today.
HOW RISK TOLERANCE AFFECTS YOUR FUTURE
December 8, 2022
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