Every investor’s risk tolerance is different, as is their own definition of risk. Risk encompasses the investor’s ability to tolerate risk as well as the risk of the investment itself. All investments carry some amount of risk.
If you can open your account statement and see that your investments are down 50% and say, “I like my financial plan and feel it will help me accomplish my goals. I like my adviser, and I understand the market has fluctuations. If I continue to invest, I’ll be buying stocks at a cheaper price,” then you have a strong risk tolerance. On the other hand, if your reaction would be to call your adviser and scream, “SELL!” then you are risk averse.
Most investors fall in between those two extremes, which is why we recommend following the Ten Year Rule, which states that any money you do not need within the next 10 years should be in growth investments, such as stocks. If you are in your early 40s, this would be the money in your 401(k) and retirement accounts—money you will not likely touch until you are 65 or 70. This money has at least a 25-year time horizon; therefore, you should be able to withstand the inherent fluctuations of the stock market. You can also spread your risk among various asset classes, such as, Large-Cap, Mid- or Small-Cap stocks, or International or even Emerging Market stocks.
We only recommend safer investments, such as U.S. Treasury bonds or high quality municipal bonds, as you near retirement, and even then, we suggest only allocating the portion of the money you’ll need within 10 years to fixed-income investments. According to the 2015 Ibbotson’s Yearbook, the rolling 10-year average return for Large-Cap stocks is 10.5%. The market may not actually return 10.5% in a given year. It is often significantly higher or lower. To achieve anything similar to a 10.5% annualized return, you need to have a long time horizon. If you were to allocate 10% of your portfolio to bonds, your 10-year average return would drop to 10.1%. While that may not seem like much, over a 25-year investment period, it could add up to tens of thousands of dollars you may miss.
When it comes to individual investments, risk is often referred to as volatility. Volatility is inherent with common stocks. When you are researching stocks or even wealth managers, you’ll encounter plenty of terms described as risk measurements. These measurements should be used to give you an idea of how much volatility you can expect.
Overall, volatility should not scare you, as it is part of investing. Some stocks are less volatile than others. Beta is a measure of volatility. A beta of 1, generally, indicates the security is just as volatile as the market as a whole. A beta of less than 1 indicates that the security should be less volatile than the market, while a beta greater than 1 indicates more volatility than the market. For example, if a stock’s beta is 1.2, in theory, the stock should move 20% more than the market—in either direction.
Alpha shows how much an investment or portfolio outperforms the market on a longer term basis. With alpha, you also need to consider you may not be comparing apples to apples. For example, if your conservative portfolio that contains a portion of bonds is compared to the S&P, which does not contain bonds, as a benchmark, you may often have a negative alpha.
Another measure of volatility is standard deviation, which gauges the degree of an investment’s up-and-down moves over a period of time. From a portfolio perspective, standard deviation shows how much a portfolio’s returns have deviated from its own average. Another common term, R-squared, can help you predict how closely correlated the movements of the security or portfolio are to the benchmark.
Investments are also influenced by both systematic and unsystematic risk. A systematic risk affects the market as a whole, such as a worldwide recession. Systematic risk can rarely be eliminated. On the other hand, unsystematic risk affects a specific investment, such as an accounting fraud scandal. With a diversified portfolio of well-researched investments, you can nearly eliminate unsystematic risk.
Overall, you should be able to mitigate risk or volatility in your portfolio and financial plan. However, it begins with being realistic about the risk level in your portfolio and how much time you have to recover from potential downturns. If you have questions regarding the risk in your portfolio, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
Disclosures: This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
