When it comes to investing, risk is arguably the most important variable to consider. The risks you take can make or break your bank account – and your foreseeable future.
The amount of risk you take on in your investments is important for a few reasons:
- You can’t fully capitalize on your potential gains without taking some risk
- Watching your account balance rise and fall with market swings can be agonizing mentally and emotionally
- Taking on too much risk in an inopportune stage of your investing career can be devastating to your financial goals.
As risk commands such a significant role in your investments, it’s essential to be knowledgeable on crucial components of your portfolio, including:
- The amount of risk each asset class strings along
- Your risk tolerance
- Your risk capacity
In this article, we’ll cover several asset classes and their levels of risk. We will also offer some tips on making rational, responsible decisions when it comes to risk exposure in your portfolio.
Risks Involved with Equities
We’ll start with the “sexiest” of the traditional asset (investment) classes: equities, or stocks.
Generally speaking, equities tend to carry the highest level of risk when compared to bonds and cash. Primarily, this is due to the fact that there is no underlying guarantee you will get your principal (original investment) back when you sell your position – let alone see any gains.
In the worst-case scenario – company bankruptcy – common stock shareholders are among the last people to get paid back. It’s not unheard of for these shareholders not to get paid back at all after bankruptcy proceedings.
In finance, one major factor to consider is the law of risk versus return, where the market rewards responsible risk. While risk doesn’t exactly translate to return, you are more likely to see high returns in riskier asset classes overall. However, investing more in these tenacious endeavors comes with increased prospects of losing your principal.
There are a lot of different ways to evaluate the risks any one particular stock will face. For the sake of simplicity, we’ll cover a fundamental topic: company size.
- Stocks represent ownership in companies
- The more stocks you own, the larger percentage of the company you own
- Companies differ in size (market capitalization)
Generally speaking, the larger a company is (valuation), the better it will fare through a severe economic downturn.
Larger companies, as a rule, tend to have stronger balance sheets that can see them through recessions. On the other hand, smaller companies – especially tech startups – struggle and may face the possibility of bankruptcy.
Therefore, it’s no surprise that many “plain Jane” blue chip stocks held up through the 2008 economic downturn and the coronavirus panic market. Blue chip stocks are large, established companies with deep pockets and excellent reputations, such as IBM and Microsoft. Value companies such as these won’t provide you with the most lucrative returns in terms of capital gains, but they can be great holdings when the market turns ugly (as it inevitably will). This has become even more relevant as the historic bull run of 2019 inevitably died.
The Risks of Fixed Income
Let’s move on to the next asset class: fixed income, more colloquially known as bonds.
Bonds are less risky than stocks because they promise a minimum return on your principal. In short, bonds are IOU investments wherein you agree to loan money to a company or government. In return, the bond issuer promises to pay you back on a set date – with interest. Most bonds pay fixed interest rates on percentage of the par value (the amount you’ll get at the term’s end).
Once again, there are dozens of ways to classify the risk of your investment. For now, we’ll stick with the interest rate.
Bond prices and their yields have an inverse relationship. As interest rates go up, current bond prices go down, and vice versa. This makes time an important element for gauging interest rate risk.
Generally speaking, the longer the term of the bond, the riskier buying the bond is. This is a result of fluctuating interest rates, which have more time to move compared to a short-term bond.
To compensate for and offset this risk, investors often demand a higher rate of return (interest) on longer-term bonds.
Cash: The Least Risky of All?
The last asset class we’ll cover is cash.
Cash (such as a personal checking or savings account) is considered the least risky of the traditional asset classes. It is designed to be a steady, guaranteed asset to park in an account and maintain its value without being subject to increased market fluctuations.
Due to the law of risk versus return, you will experience very little growth in your cash accounts. With current short-term interest rates stuck below historical averages, this is true now more than ever.
However, cash comes with a hidden risk: inflation. This is the process of losing purchasing power over time due to increases in expenses (also measured as a decrease in the value of the money itself). If you keep the majority of your assets in cash, you put yourself at the whims of inflation. Worst-case scenario, you lose the bulk of your net worth without spending a dime.
The United States economy averages a 2% inflation increase annually. For a simple example, if you have $1 today, in 365 days you’ll be able to purchase $0.98 worth of product on that same dollar.
This risk of inflation is why advisors typically warn younger investors against tying up their investable net worth in cash. Rather, it’s wiser to invest in assets that have growth potential throughout the accumulation phase.
Your Risk Tolerance
Your risk tolerance is another critical element of your investment potential and risk equation.
Risk tolerance is the amount of risk you’re comfortable taking when you determine your investments. In other words, how well you handle volatility (specifically drops) in the market.
Risk tolerance is a tricky subject to discuss because it’s difficult to quantify. Studies show that humans tend to overestimate their risk appetite – as anyone who has worked finance can attest. To help combat our inherent propensity for risk, there are a great many online questionnaires that give you an idea of where you stand concerning your tolerance. However, the only way to really know your level of comfort is to experience volatility first-hand.
Risk is very, very real in investing. Ignoring your risk tolerance is arguably the worst decision you can make as you embark on your investment career. If you’re working with a financial advisor, work to facilitate an open, honest conversation about the level of risk you can stomach. If the market bottoms out and you discover you handle stress surprisingly well (or melt down entirely), you can always reevaluate your decision.
The worst time to decide you’ve bitten off more than you can chew is when markets take a severe hit. Be proactive and do your best to put together an allocation that respects your tolerance for volatility.
Your Risk Capacity
Risk capacity is the last topic we’ll cover regarding the risk equation. While this subject matters just as much in determining your financial decisions and fiscal goals, we don’t talk about it nearly enough.
In short, your capacity for risk is how much risk you can statistically afford to take.
As a general rule, the more time you have, the more likely you are to recover from recessions and downturns. This is excellent news for younger investors and not-so-great news for investors who are nearing their exit from the workforce. A bad market at the start of retirement can be devastatingly fatal for even the most solid financial plan. This concept is referred to as “sequence of returns” risk.
There are a few different ways to measure your risk capacity, one of the most accepted being the Monte Carlo analysis. This is a simulation that many advisors use to gauge how successful a client will be in meeting their investment objectives given a wide range of market return scenarios.
This analysis provides a financial advisor with the likelihood of success based on the number of times a financial plan “succeeded” throughout thousands of simulations.
When constructing your asset allocation, bear in mind that your risk capacity is one of the most important variables. This factor of the equation only increases in important the older you get.
How Much Risk Should I Be Taking?
This question can only truly be answered by yourself and a dedicated financial professional. Hopefully, this article laid the groundwork to helping you understand the different concepts of risk and define where you stand.
Always, always, always educate yourself on the risks of any financial decision. This goes for large and small investments alike, from throwing capital into the stock market to opening a bank account. Familiarize yourself with the various asset classes and the risks associated with and shared among each.
Be honest with yourself on your risk tolerance. Even veterans in the investment game have to consider the fact that the last ten years have been comparatively tame in terms of volatility – just look at the extreme highs and lows brought about by the global coronavirus pandemic. Being proactive in accurately gauging your risk tolerance before volatility strikes will save you some major panic down the road.
Lastly, understand and capitalize on your capacity for risk. If you’re younger, you can statistically afford to accept more risk in your journey to amp up your net worth. If you’re older, however, the risks may just not be worth it.