Most of us are familiar with the concept of investment risk. When investing in the stock or bond market, account values can increase or decrease depending on market activity. You probably have heard about risk tolerance as it relates to investments. Risk tolerance often is used to determine the type of investments used to build a portfolio.
It’s a good component of your risk profile, but did you know there are two additional components that may be even more significant? These are risk capacity and time horizon. Let’s look at these, and how they relate to investment choices, after a quick review of risk tolerance.
The simplest definition of risk tolerance is the amount of variability, or potential loss, a person is willing to accept with their investments. You probably have heard that greater investment returns require you to accept increased investment risk. This is generally true, but it does not address how that increased risk impacts your mental and emotional well-being. To gain an understanding of the impact, you, or your investment professional, often will complete a risk tolerance questionnaire. The results of this questionnaire will be used to guide investment portfolio development. Understanding your risk tolerance is important but it’s not the only component in your risk profile you should consider.
Your financial resources—your assets, investments, and cash flow—act as a starting point, indicating where you are and what has yet to be done to meet your goals. Personal financial resources dictate the need for an investor to take risk. For example, investors with more than enough resources to meet their goals have no need to take much investment risk and can focus on conservative investments. Alternatively, someone who needs their savings to grow 7–8 percent per year to meet their goals would need to accept more risk. In other words, risk capacity indicates how much risk you must accept to achieve your investment goals within your personal time horizon.
Time is one of the most significant factors in investing. Your investment time horizon is the period from now until money is needed for a financial goal. A financial goal with a high degree of certainty and a short time period requires a focus on capital preservation, and therefore a selection of assets that remain stable in value. For example, an investor who plans to make a down payment on a house six months from now would want to keep that money in an asset with minimal risk, like a six-month certificate of deposit or money market account. Longer time horizons can allow for investments that, though they will fluctuate in value, offer increased appreciation potential. For example, if the investment goal is accumulating $1 million for retirement 25 years from now, investments with higher long-term expected returns like common stock or long-term or high-yield bonds may be appropriate.
One of the biggest dangers to investing is overreacting to short-term market movements. Short-term volatility should be mostly irrelevant to people with a long-term investment time frame, because the longer an investor can hold an investment, the more likely he or she can ride out market volatility and achieve positive results. In other words, the longer the time horizon of the goal, the less risky are growth investments such as common stocks.
What this Means to You
When considering the risk/return relationship that is central to investing, most investors concentrate on returns. This is understandable because people invest to make money. Risk, or the possibility of loss, on the other hand, is the aspect of investing that investors would like to avoid or minimize. However, a strong argument can be made that, for good long-term results, investors should first concentrate on controlling and managing risk.
Investors should understand that every investment has some risk. Even a bank certificate of deposit that does not fluctuate in value has purchasing power and credit risk. The issue is not avoiding risk, but rather, taking appropriate risks. Therefore, understanding portfolio risk is quite important. We will explore portfolio risk in another article.
When you decide to invest, consider all three aspects of your risk profile: risk tolerance, risk capacity and time horizon. Doing this will help you develop a retirement portfolio that will allow you to accumulate the money you need, when you need it. You will also be able to sleep at night with a good understanding of how your investments will likely respond to market variability.