The risk of losing money is understandably a big fear for investors. Investing is a great way to grow your wealth, but there's a tradeoff. The opportunity for your investments to rise is accompanied with the risk they might fall (risk and reward).
Everyone's ability to handle risk is different, a risk-appropriate portfolio is key to successful investing. Investors taking on too much risk are likely to make poor decisions under pressure (like JR Smith in the NBA Finals). Investors who are too conservative are limiting their growth potential.
Most portfolios are built with a mix of stocks and bonds. Stocks are typically riskier and provide greater returns, bonds are typically more stable and provide lower returns. A paper by PWL Capital found that stocks had an expected return of 7% and a standard deviation of 11.4%, while bonds had an expected return of 3.3% and a standard deviation of 3.9%.
Standard deviation is the degree that returns deviate from the annual average. The higher the standard deviation, the more volatile your returns. To expect higher returns in the long run, you must be willing to subject yourself to higher volatility in the short run.
There are two factors to understanding your risk tolerance - your ability to take risks and your willingness to take risks. Ability is a function of your time horizon and willingness is a function of your personality.
Time horizon is a fancy way of saying when you'll need the money, like pugilism is a fancy way of saying boxing (and boxing is a fancy way of saying fist fight). If you have a long time horizon (10+ years), you're able to endure more market volatility. You can ride out recessions and enjoy the expected long term growth of the stock market.
If your time horizon is short (say less than 5 years), you can't afford the risk of a market downturn. The sooner you need the money, the more stable your investments should be. You wouldn't want to be near retirement, only to have your investments cut in half (see 2008).
Willingness is about your personality. When markets are down, will you lose sleep? Will you make impulse decisions? If you can't stomach the rollercoaster ride of returns, you should allocate more to stable assets such as bonds.
Willingness is often overlooked when determining risk tolerance. Remember, you have to be both able AND willing to take risks. A young professional with decades to retirement is able to take on more risk, but if their personality lends them to be frantic in turbulent times, then a portfolio of mostly stocks won't be right for them.
Understanding your risk tolerance is the foundation to your financial plan. Before you jump into investing, take the time to understand yourself and your ability to handle risk.
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