The level of risk exposure that an investor takes on is fundamental to the entire investment process. Despite this, investors often misunderstand this issue and both brokers and investors can spend far too little time determining appropriate risk levels.

There are articles, books and pie charts galore out there that deal with the categorization of risk for practical investment purposes. However, many investors have never seen this literature, or, at the time of investment, do not understand it. Consequently, many people just check off "medium-risk" on a form, thinking, quite understandably, that somewhere between the two extremes "should be about right".

However, this isn't the case as products are often misrepresented as medium-risk or low risk. Furthermore, the appropriate category for an investor depends on several factors such as age, attitude to risk and the level of assets the investor owns. In this article, we'll introduce you to portfolio risk and show you how to make sure that you aren't taking on more risk than you think. (For more insight, see Determining Risk And The Risk Pyramid.)

How does it work in practice?
Very few people are truly high-risk investors. For most, therefore, an all-equity portfolio is neither suitable nor desirable. Discretionary income can certainly be put into the stock market, but even if you don't need this money to survive, it still can be difficult to see surplus funds disappear along with a plummeting stock.

As a result, regardless of their level of disposable income, many people are happier with a balanced portfolio that performs consistently, rather than a higher risk portfolio that can either skyrocket or hit rock bottom. A medium- to low-risk portfolio made up of somewhere between 20% and 60% in equities is the optimum range for most people. An all-the-eggs-in-one basket portfolio with 75%+ equities is suited to a rare few. (To learn more about portfolio construction and diversification, see The Importance Of Diversification, Major Blunders In Portfolio Construction and A Guide To Portfolio Construction.)

The most fundamental thing to understand is that the proportion of a portfolio that goes into equities is the key factor in determining its risk profile. Most sources cite a low-risk portfolio as being made up of 15-40% equities. Medium risk ranges from 40-60%. High risk is generally from 70% upwards. In all cases, the remainder of the portfolio is made up of lower-risk asset classes such as bonds, money market funds, property funds and cash.

Some Sellers Push Their Luck … and Yours!
There are some firms and advisors who might suggest a higher risk portfolio - if they do, beware. It is theoretically possible for a portfolio to be so well managed that it is mainly comprised of equities and has a medium risk. But in reality, this does not happen very often and the percentage of equities in the total portfolio does reveal the risk level pretty reliably.

As a general rule, if your investments can ever drop in value by 20-30%, it is a high-risk investment. It is, therefore, also possible to measure the risk level by looking at the maximum amount you could lose with a particular portfolio.

This is evident if you look at a safer investment like a bond fund. At the worst of times, it may drop by about 10%. Again, there are extremes when it is more, but by and large, the fluctuations are far lower than for equities.

Why then do people end up with higher risk levels than they want? One potential problem is that the industry often makes more money from selling higher-risk assets, creating the temptation for advisors to recommend them. (To learn more, read Is Your Broker Acting In Your Best Interest?)

Also, investors are easily tempted by the huge returns that can be earned in bull markets. They tend not to think about possible losses, and they may take it for granted that their fund managers and brokers will have some way of minimizing or preventing losses.

Despite the potential upside, when the equity markets go down, most equity-based investments go down with it. For this reason, the most important and reliable way of preventing losses and nasty surprises is to keep to the basic asset allocation rules and to never put more money into the stock market than corresponds to the level of risk that is appropriate for you. (For further reading, check out Achieving Optimal Asset Allocation and Asset Allocation Strategies.)

The Risk Dividing Lines Are Clear Enough
If there is one thing investors need to get right, it is the decision about how much goes into the stock market as opposed to safer and less volatile investments. There really are clear dividing lines between the categories of high, medium and low risk. If you make sure that your portfolio's risk level fits into your desired level of risk, you'll be on the right track.

Related Articles
  1. Investing News

    Negative Interest Rates and QE: 3 Economic Risks

    Along with quantitative easing (QE), unconventional monetary tools are meant to stimulate economic activity, growth, and a moderate level of inflation.
  2. Investing Basics

    Contingent Convertible Bonds: Bumpy Ride Ahead

    European banks' CoCos are in crisis. What investors who hold these high-reward but high-risk bonds should know.
  3. Mutual Funds & ETFs

    The 3 Best T. Rowe Price Funds for Value Investors in 2016

    Read analyses of the top three T. Rowe Price value funds open to new investors, and learn about their investment objectives and historical performances.
  4. Active Trading Fundamentals

    4 Stocks With Bullish Head and Shoulders Patterns for 2016 (PG, ETR)

    Discover analyses of the top four stocks with bullish head and shoulders patterns forming in 2016, and learn the prices at which they should be considered.
  5. Investing

    3 Healthy Financial Habits for 2016

    ”Winning” investors don't just set it and forget it. They consistently take steps to adapt their investment plan in the face of changing markets.
  6. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  7. Fundamental Analysis

    3 Reasons To Not Sell After a Market Downturn

    Find out the reasons that it is not a good idea to sell after a market downturn. There are lessons to be learned from the last major market downturn.
  8. Fundamental Analysis

    HF Performance Report: Did Hedge Funds Earn Their Fee in 2015?

    Find out whether hedge funds, which have come under tremendous pressure to improve their performance, managed to earn their fee in 2015.
  9. Sectors

    2016's Most Promising Asset Classes

    Find out which asset classes are considered to be the most promising for generating portfolio returns and reducing volatility in 2016.
  10. Mutual Funds & ETFs

    3 Morgan Stanley Funds Rated 5 Stars by Morningstar

    Discover the three best mutual funds administered and managed by Morgan Stanley that received five-star overall ratings from Morningstar.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What's the difference between a stop and a limit order?

    Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you ... Read Full Answer >>
  3. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  4. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  5. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  6. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center