Would you rather have a guaranteed $10,000 today or the opportunity to earn anywhere from $5,000 to $20,000 over the next twelve months? Are you willing to risk a sure thing for the opportunity for more?
Your answer to that question should be dependent upon two factors: your tolerance for risk and your ability or financial capacity to take risk. The two are completely independent, but they must be consistent, especially when it comes to building an investment portfolio. (For related reading, see: What Does Investment Diversification Really Mean?)
Risk tolerance refers to how much volatility or fluctuations in your account balances you can stand and still be able to sleep at night. Oftentimes people think they can handle more risk than they actually can. Think back to the last market downturn when you saw your portfolio drop in value. What did you do? Did you panic and get out of the market? Did you sit tight and not give the downturn much thought? Did you invest more?
It is important to be honest with yourself when assessing your risk tolerance because you don’t want to take on more risk than you are comfortable with—the last thing that you want to do is abandon your plan or make investment decisions out of fear. Staying the course is critical to being a successful investor so it is imperative that you get on the right course to begin with. (For related reading, see: What Is Your Risk Tolerance?)
While risk tolerance refers to how much risk you can psychologically handle, risk capacity refers to how much risk your plan can withstand. In other words, would you still be able to reach your goals if a bad outcome occurred? There are several factors that affect your ability to take risk:
- The longer your time horizon and the more flexibility in timing, the greater your risk capacity.
- If you have multiple sources that will fund your cash needs in addition to your investment portfolio, the greater your risk capacity. You are not completely reliant on your portfolio.
- The more stable and protected those other sources of funds are, the greater your risk capacity.
Regardless of one’s risk tolerance, a young person just starting out in the workforce who is contributing to a 401(k) has a high capacity for risk – the funds in that account will not be accessed for a long time so the ups and downs of the market will not be an issue. But a 60-year-old who is contemplating retirement within the next few years may or may not have the capacity to be as risky with his retirement assets—it will depend upon his other resources and whether or not he will be tapping into that 401(k) sooner rather than later.
Just because you have the financial capacity to take risk doesn’t mean that you should. And just because you have a high tolerance for risk does not mean that you are in a situation where you can take risk. It is a delicate balancing act and a financial advisor who has your best interests at heart will help you to determine where you belong on the risk spectrum. This is one of the big decisions you want to get right as it will be one of the biggest determinants of your investment success. (For more, see: Protecting Your Investments From Economic Storms.)