Between the Bitcoin frenzy and Tesla making rockets and 18-wheelers, I've been getting a lot of calls recently about whether or not to invest in the latest and supposedly greatest things to hit the market. And while I can't tell you in five seconds whether or not to invest in something I know nothing about (I mean honestly, how many people can truly explain Bitcoin?), I can tell you a little something about the decision-making process you're going through: it's called determining your risk tolerance, and today we're here to help you figure it out.
What Is Risk Tolerance?
Risk tolerance is exactly what it sounds like: the amount of risk you are comfortable withstanding. In investing, risk tolerance means answering the question of how much fluctuation you're comfortable with in your account(s) without feeling a need to make a change. It may seem great that your account has the ability to generate 20% returns, but if the fact that it also comes with the risk of -20% returns makes you too uncomfortable, this would be an example of something that exceeds your risk tolerance. It might make you more comfortable to find an option whose upside is smaller in exchange for a smaller window of potential losses. Determining where you fall on the risk spectrum is important when building a portfolio.
Can Different Accounts Have Different Risk Tolerances
Absolutely. Your risk tolerance shouldn't be the same for all of your accounts. Each portion of your portfolio should serve a particular purpose, and sometimes that purpose can mean investing in many different ways depending on the goals you have in mind. With that being said, here are 5 things that can help you determine your risk tolerance for your investments
How Do I Choose My Risk Tolerance?
1. Time Horizon
Whether you consider yourself an aggressive or conservative investor, the length of time that you have until your money is needed is an important part of determining your risk tolerance. Even an extremely conservative 25 year old should consider loosening the reins a bit on a retirement account, seeing as they have decades before the money is needed. As a matter of fact, for younger investors, negative market returns in some years isn't always a bad thing, as it gives you the opportunity to buy investments at a lower price. Conversely, a person who has an account they plan to use in the next few years - say for a down payment on a home, or to start a new business - shouldn't be aggressively invested, as their short time horizon means searching for consistent returns might be more appropriate than shooting for the moon.
2. Net Worth
The fact of the matter is the best time to make a risky investment is when you can afford to lose the money. If you are getting started in investing and you don't have a significant amount of assets, your investment style should reflect the fact that you can't really afford big losses. Retirement accounts are a little different, as in most cases they can't be accessed until age 59 1/2. But for accounts outside of retirement, there is nothing wrong with starting off slowly until you've got your feet under you. So while it may be trendy to put all of your life's savings into Bitcoin or Snapchat stock, the people best positioned to profit from any potential successes are those who built a firm foundation before launching into more speculative offerings.
3. Investment Objective
I'll never forget when my wife and I were about to buy our first home and we found a one-bedroom condo that fit our budget. My mother, who is a realtor, discouraged us from buying it, because one-bedrooms can be hard to resell. In her mind, she knew that as our family grew, we would eventually have to leave that condo. She then told me something I'll never forget: whenever you buy a home, you need to have an idea of what you want your exit strategy to be, because that can dictate the type of home you purchase. If you're planning to sell your home within a short period of time, you need to look for a property that makes it as easy as possible to do so. The same is true for investments; know what your goal is for any investment before you make a purchase, because sometimes that alone can determine its appropriateness in your portfolio. Have you opened an account that you plan on taking withdrawals from each year? It might be best to stick to conservative to moderate investments so that you lower your sequence of return risk. Conversely, if you're a new grandparent and want to leave some money aside for when your grandchildren come of age, it might benefit them to have investments in areas with more growth potential. Whatever your goal is, make sure that the investment you choose is one that contributes to and does not detract from that goal.
4. Investment Experience
No matter how tempting the opportunit, putting money into something you don't understand is unwise. Thankfully, the internet provides us with a vast amount of tools to use for research. If you've found a platform you're interested in, take the time to understand the potential pros and cons before taking the leap. Even if the investment itself meets your appetite for risk, there may be aspects such as its impact on taxes that need to be considered. Take a Real Estate Investment Trust (REIT) for example: a Real Estate Investment Trust is a company or collection of investors that own or finance real estate projects. By buying into a REIT, you are purchasing an interest in that company's real estate dealings. Publicly-traded REIT could invest in dozens or hundreds of properties, giving you wide exposure to the real estate market. While this aspect of REITS may appeal to you, also consider that REITs are required by law to distribute at least 90% of their income each year, which would create a taxable event for you. The impact of those taxes needs to be considered as strongly as you consider the type of properties the trust invests in to make sure it fits what you're looking for, and the same level of research should be done with any part of your portfolio.
5. Liquidity needs
While your liquidity needs may not seem to affect risk tolerance in terms of how volatile an investment might be, it COULD affect how much of a contribution you make towards that investment. We recently did a guest post for our friends at Wealth Noir about the limitations of 401(k)s; in that article one of the key points we discussed was the age you must reach to access your 401(k) without penalty (59 1/2). While the investments in your 401(k) may be wholly consistent with your investment goals, the restrictions on accessing your money are important. While this might seem similar to deciding your time horizon, where they differ is the decision of how much money you should invest, if any at all. Considering your time horizon might mean deciding whether you should contribute to a fund that's made up of 90% stocks and 10% bonds. Considering your liquidity needs could be deciding whether or not to open a CD that ties your money up for three years, and whether or not the expected return outweighs the negative affects of losing access to those funds. These are two different but equally important parts of determining your risk tolerance.
Now I hope it doesn't seem like I'm beating up on you for having an interest in some interesting things, and I certainly don't want you to think that every account you have should avoid risk. That's not the case at all. What I do hope, is that we've helped advance your knowledge on what goes into structuring your investments, so that the next time an opportunity comes along, you have the knowledge to assess its risks, rewards, and how it could be positioned in your portfolio to help you meet your goals.