Because there are so many different variables, investing for first-time investors can be overwhelming and confusing. There are different retirement accounts, investment accounts, and actual investments you can make. Some accounts let you invest in certain things but not others. However, perhaps the most overlooked item is not knowing what your tolerance for risk is. Before you invest you need to know your risk tolerance and if your investments actually reflect how much risk you are willing to take on.
For example, bonds are less volatile than stocks. Inside bonds, US government bonds are less volatile than corporate bonds. Investment grade bonds are less risky than junk bonds.
With inside stocks there are even more variables. Large-cap stocks are generally less volatile than small-cap stocks. Utility companies are generally less volatile than tech stocks. Stocks that pay a steady and growing dividend are generally less volatile than companies that don’t.
And this is only scratching the surface.
Why Is Knowing Your Risk Tolerance Important?
You probably noticed that I kept using the term “volatile” when describing “risk.” For investments, volatility means how much the price of an investment will move up or down over a period of time. In shorter periods of time, investments experience much more volatility than over a longer period of time. So when it comes to measuring risk tolerance, what we are really asking is “how much short term volatility can you, as an investor, stomach?”. If your investments are not aligned with your risk tolerance, the likelihood of you making a poor investing decision increases.
Let’s say you have a portfolio of $100,000 that is fairly diversified but only in only tech companies. This would show you are willing to take on a decent amount of risk, but in this scenario, you don’t have the appetite for risk. In this scenario, the tech market experiences a 50% decline in a matter of a month. Your portfolio is now $50,000. Since your risk tolerance is low, you panic and sell because you can’t tolerate any further declines. The market rebounds in two years all while you are sitting in cash. This is what happened during the tech crash in the early 2000s.
Now let’s look at a different scenario. There is another $100,000 portfolio, but this investor knows they are willing to give up some upside in exchange for the peace of mind knowing their investments won’t go down that much in a bear market. Their portfolio is well diversified comprising of stocks, bonds, commodities, REITs, and cash all in line with their risk tolerance. The tech market goes down 50% while the S&P 500 goes down 35%. The investor’s portfolio goes down 20%. Thinking the market will rebound someday, the investor then uses the cash they have to buy stock in companies who have a solid history while their prices are low. Instead of panic, they are using the downturn as an investing opportunity.
That’s one example of the power of knowing your risk tolerance.
One other variable for risk tolerance is time. When will you need to access the money? Is it 30 days or 30 years? The longer your time frame, the more risk you should be willing to take.
Ask yourself this question: If you start with $100,000 and need it 2 years from now to put towards a down payment on a house, which scenario would you rather have?
Scenario A – There is a 50% chance your portfolio will be worth $150,000 and 50% chance it will be worth $60,000.
Scenario B – There is a 50% chance your portfolio will be worth $95,000 and 50% chance it will be worth $110,000.
Which scenario did you pick?
Now let’s assume your time horizon is 30 years. And instead of needing it for a down payment you need it for your retirement.
Scenario A – There is a 95% chance your portfolio will be worth $150,000 and 5% chance it will be worth $60,000.
Scenario B – There is a 50% chance your portfolio will be worth $95,000 and 50% chance it will be worth $110,000.
Which one did you pick now?
Clients of Melby Wealth Management take a comprehensive risk tolerance quiz as part of the services we offer. If you’re interested in learning more about the services Melby Wealth Management provides, I encourage you to visit our website here.
Full Disclosure: Nothing on this website should ever be considered to be advice, research or an invitation to buy or sell any securities. Please see the Disclaimer page for a full disclaimer.
About The Author
Shaun Melby, CFP® provides fee-only financial planning and investment management services in Nashville, TN. Melby Wealth Management serves clients as a fiduciary and never earns a commission of any kind. Shaun has over 10 years of experience as a financial advisor in Nashville.