Investing money is an inherently uncertain practice, so it's important to understand the risks involved and how they work. Taking on greater risk gives you the potential for both greater gains and losses over the long term. But if you have financial goals for the shorter term or are about to retire, one major loss may impede an investment's ability to last through retirement.
Knowing your investment risk tolerance is key to building a financial strategy and managing your reactions to cycles in the market.
What Is Investment Risk?
Systematic Risk
Systematic risk, also referred to as market risk, is how your investments move in conjunction with the overall market. Diversification can't help mitigate systematic risk. It's market-wide and all investors are prone to it.
An investing metric called "beta" is one way to measure this risk. Mutual funds, for example, will often measure beta to compare a fund's movement to that of the market. A beta of one means an investment is in sync with the market. An investment with a beta of more than one fluctuates more than the market, while an investment with a beta lower than one moves less than the market. The higher the beta value, the more risk involved (but the more potential there is for higher returns).
Inflation Risk
Inflation risk, also known as purchasing power risk, is the risk that your investment will lose value over time, or have less purchasing power, due to inflation. This risk is most likely to impact fixed-income investments, which don't adjust for inflation.
Liquidity Risk
If you choose to sell an investment, there's a chance you won't be able to sell it due to a lack of interested buyers. This is commonly referred to as liquidity risk. If this is the case, you may need to keep the investment or sell it at a loss in order to attract buyers, meaning you'll ultimately receive less money for the investment than you originally paid for it.
Sequence Risk
In retirement, one of the most prevalent risks associated with investing is sequence risk, or sequence-of-returns risk, which acknowledges that timing plays a role in an investment's return. There's the risk that the market will be down when you start withdrawing money from an investment, reducing your available income as well as the investment's overall returns — you may have to break into the investment's principal in order to meet your income needs.
"Utilizing a bucket strategy is a way to address the various levels of risk for each of your specific goals," says Kate Brown, vice president and senior wealth planner. She goes on to explain that a bucket strategy refers to time horizon and is simply a mixture of shorter- and longer-term investments made with an eye to certain life events. For instance, saving for a home is a shorter-term investment, while retirement is longer term.
"Planning becomes crucial, because knowing you're going to retire soon, you can proactively plan for that," says Brown. "If we can define money that is for retirement we can withstand more volatility, because we have more time versus college, buying a new house or paying for a wedding, which are shorter-term. Creating different accounts for each of those goals, we can be more customized and take the appropriate risk."
What Is Risk Tolerance?
In general, risk tolerance is the amount of volatility you're willing to withstand with your investments. "The goal isn't just to maximize risk but to accomplish your goals while not taking unnecessary risk," explains Brown.
There are three primary categories of investment risk tolerance: aggressive, moderate, and conservative.
Aggressive investors seek higher returns, but are subject to greater market risk. Moderate investors typically diversify and utilize higher- and lower-risk investments in order to balance their portfolios. Conservative investors are more willing to accept lower investment returns and maximize safety to preserve what they've accumulated.
No results are guaranteed for any risk management style; a conservative investor could still experience deep losses, while an aggressive investor might potentially see relatively little change.
How Do I Know My Risk Tolerance?
Although risk tolerance is a measure of how much risk you can handle, it doesn't always correspond to how much risk you should take. "You have to be confident the investments are consistent with your goals, priorities and cash flow, and oriented with the protection needed," advises Brown.
One way to find your investment risk tolerance is to look at different scenarios and what actions you might take in response. Also, time needs to be considered when determining your overall goals. Those with a stable income, or income that hasn't fluctuated and is from a consistent source, tend to have longer-term goals and might consider a more aggressive approach that allows time for market corrections and recoveries. "Be aware of what you need from that portfolio, and make sure it reflects that," says Brown.
Since risk tolerance is the willingness to take on more risk in exchange for higher returns, it's likely to change as you get older. It can be beneficial to evaluate your investment strategy periodically; as your financial goals and assets change, consider adjusting your risk tolerance and diversifying appropriately.
