The stock market can be volatile. This we all know. If you were investing in 2008, then you know precisely how upsetting it can be when the volatility means big losses. So, imagine a day when one of your equities drops by 40 percent in mere minutes. On August 24, 2015, this happened. Exchange-traded funds (ETFs) declined about that much only minutes after the opening bell rang.
What would your reaction be if you had owned one of those ETFs? Would you:
- Sell it at the loss and move it into a money market or bond?
- Take the opportunity to buy given the low stock price?
- Do nothing?
This is not a cautionary tale but rather an exercise in fastidiousness or, at the very least, awareness of who you are as an investor and what that means for your portfolio strategy.
There is no right answer. Whatever the answer you find most palatable or aligned with what you would do says a lot about what type of investor you are. And knowing what type of investor you are is extremely helpful in determining what the makeup of your portfolio is.
So, if the first answer is likely what you would have done, then you are mostly conservative and risk-averse. You are also prone to recency bias, which, incidentally on a macro level, is what causes market volatility. With this type of risk profile, your portfolio strategy would likely want to favor more fixed income than securities since they fluctuate less than stocks.
If you chose option 2, then you are more willing to live on the edge, take bigger risks in the effort to gain bigger rewards. This aggressive approach can bode well in some instances and a higher percentage of equities in your portfolio will be something you are not only comfortable with but will benefit from over the long-term.
For those who chose option 3, it is obvious that you are patient and more moderate in your investing approach. Keeping a balanced portfolio with a mixture of slightly more stocks than bonds would probably be a good place to begin.
There is more to risk profile than your tolerance
So, is your relationship with risk all about what your tolerance level is? The answer is certainly not. When you are determining what your asset allocation should be factoring risk tolerance alone could be detrimental to your long-term performance. The aforementioned categories are a good place to start when you’re defining your investor profile. But these definitions are too broad to be useful. As you can expect, people are more complicated than these three simple categories. Yet, many self-guided tools for investor profiling don’t go much deeper than this in helping individual investors choose a strategy that fits their goals.
A true risk profile takes into account your age, your goals, how much money you can invest, how much you need to fund your retirement and other savings goals, and so much more. It is in this area, that is broad and complex, that a financial advisor can add value when compared with just going it alone. With experience, an objective opinion and specialized tools to help fine-tune and personalize your investment strategy, a financial advisor can help you make decisions that may mitigate your tax burden, lower trading costs and protect you from making choices that are inappropriate for your comprehensive risk profile.
Measuring your risk tolerance is not just about your comfort level with losses. The truth is, no one is comfortable with losses. Even the most aggressive investors would be distraught to experience a 35 percent loss on an investment in one day. A good financial advisor will not just talk about your comfort level with risk, but also how willing you are to take risks with your investment capital.
A great place to learn more about your comprehensive risk profile is through our planning tool Riskalyze. Here you can get your true risk number and get started on an investing strategy that fits who you are and what your needs are. GET YOUR RISK NUMBER HERE.