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.