Why All Investors Should Know Their Risk Tolerance

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A critical practice for new and experienced investors is creating and maintaining a financial plan based on one’s financial goals. These goals may be to pay off student loans, save for a house, take a nice vacation, and more. While many investors may focus on the portfolio returns needed to achieve these goals, the amount of risk they are able and willing to take is just as important. In this context, risk can be defined as the possibility that these goals aren’t met because the stock market has fluctuated, interest rates have risen, or due to other factors. Being honest with yourself to determine how much risk you can tolerate, either based on the funds you will need or because you won’t be able to sleep well at night, is a critical part of building a financial plan.

Financial professionals and tools can help investors outline and implement their own plans and measure their risk tolerance. All investments involve some measure of risk, and the presence of risk in investing can be concerning to even seasoned investors. 

A straightforward example of this tradeoff can be illustrated by comparing a U.S. Treasury bond with a publicly traded stock. A Treasury security has a precisely defined payout schedule and, since it is guaranteed by the United States Federal Government, the risk that the investor isn’t repaid is low. In contrast, a publicly traded stock’s value is determined by many factors that can change quickly. As a result, the value of a stock is much more volatile and can swing on a daily basis, and thus is riskier.

Maximizing the returns of a portfolio while minimizing risk is one of the main goals of every investor and there are many ways to achieve this. Perhaps the most basic method to minimize risk is diversification. Diversifying one’s portfolio across many assets that have varied returns can help to smooth one’s returns over time. For example, bonds and stocks are often negatively correlated, meaning they often move in different directions. When stocks perform poorly, bonds tend to offer positive returns. Thus, combining these together in a diversified portfolio can help to balance returns over time.

In addition, many investors take advantage of Exchange Traded Funds (ETFs) to help them diversify their portfolios. ETFs are financial instruments that are constructed to track market indexes, sectors, commodities, etc. ETFs directly hold the underlying investment and maintain an allocation to track their targets. For example, the S&P 500 is a major market index that tracks 500 large companies listed on U.S. exchanges and there are many ETFs that target the performance of the S&P 500 by holding some or all of the stocks within the index. In exchange for the service that ETFs provide, buyers typically pay a percentage-based fee to the fund managers.

An additional benefit of ETFs is rebalancing. Rebalancing is the periodic reallocation of stocks and bonds in an investment portfolio to ensure that the portfolio continues to match the financial plan. For example, let’s say you set an investment plan to buy stocks directly holding 50% of the portfolio in stock A and 50% in stock B. If you had $1,000 to invest, you would buy $500 of A and $500 of B. Imagine that at the end of the year the price of A has increased and your holdings are now worth $800, while the price of B has remained constant. Your total portfolio is now worth $1,300, so your allocation of A and B are roughly 61% and 39%, respectively. Your portfolio has drifted away from its target 50/50 allocation, and you would need to sell some of stock A and buy some stock B to achieve your target allocation again.

With an ETF, this is taken care of for you. ETFs are regularly reallocated to avoid drift from the indices they track. Thus, ETFs are a great way to diversify one’s portfolios to manage risk, while protecting against portfolio drift.

Key to any financial plan is the discipline and desire to stay committed over time, across market conditions. While weathering volatility and staying true to one’s financial plans is much easier said than done, it has historically served investors well.

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