Many of us would love to manage our own investments, but it can be overwhelming to know where to begin. Do we use stocks, bonds, futures, commodities, or real estate? Should we go long, buy on margin, short a stock, or put everything into CDs?
You could, of course, dive into these topics individually, but if you are trying to manage your own risk, you first have to determine your risk tolerance. From there, you can manage your accounts based on how much risk you want to take on and how much active managing you want to do.
Determining Your Risk Tolerance
Risk tolerance is an incredibly important aspect of getting started in investing. Depending on your age, income, investments, and goals, you will fall into one of five risk categories:
- Very aggressive
- Very conservative
The easiest way to get a feel for which end of the spectrum you fall is to go by age. If you’re young and just starting your career, you will fall toward the very aggressive side of the spectrum, while if you are older and approaching retirement, then you are likely near the very conservative side. Take a risk tolerance questionnaire to determine exactly where you fall.
There are some slight variations, but managing your risk is similar in all five categories.
Managing Risk as a Very Aggressive Investor
If you qualify as a very aggressive investor, you have things pretty easy. Simply put, you will want all of your investments to be in stocks (equities) and none in bonds (fixed income). Some may argue that having a small portion in bonds is essential, but the truth is, you need the most growth to give your account a huge boost while you’re young.
Having a 100 percent equities portfolio also means that you are taking on a lot of risk. To manage that risk, most people will put all of their money in mutual funds. These funds are spread out through hundreds of different stocks and minimize the risk of any one company going bankrupt and ruining the fund.
For example, take Enron — you could have made a ton of money investing everything in this company, but would have lost everything when they went bankrupt. Mutual funds help minimize single-security risk.
Keep in mind that you will still want to have a cash equivalent emergency fund, equity in your house, and other non-investment accounts, so you won’t truly have everything invested in stocks.
(For more, see How to Construct a High-Risk Portfolio.)
Managing Risk as an Aggressive Investor
Similar to the very aggressive investor, as an aggressive investor, you will want to have a large portion of your account invested in equities. However, your account will also incorporate large-cap stocks — those companies that are well established and the risk of failure is minimal — and some bonds. The large caps and bonds won’t grow as quickly as other equities, but if the economy is in a downturn, they won’t drop in value as much either.
Your biggest risk here is similar to that of the very aggressive investor. You want to spread the risk around with mutual funds so you don’t lose everything (or a big portion) in one market downturn. This means that if you have company stock that you have accumulated over the years, it may be time to cash some of that in to redistribute the risk.
An aggressive investor will have an account that is between 70 and 90 percent equities, with the remaining 10 to 30 percent allocated to fixed income.
Managing Risk as a Balanced Investor
Those well into their working careers, but still a decade or two from retirement, will likely be balanced investors. You are done taking substantial risks, and now want steady growth. Your biggest risk is that a huge market downturn (like we saw in 2008 and 2009) could devastate your investments and cause your retirement plans to be thrown off completely.
To combat this risk, you need to move into more equities and possibly look at some alternative investments. Changing your allocation to between 40 and 70 percent equities will minimize a lot of the market fluctuations. When looking at the graph of your investments, the growth will be steadier, but slower than your aggressive counterparts.
Keeping more money in cash while looking into real estate and precious metals will help to keep your account at a more even keel than having everything traditionally invested.
(To learn more about risk and return, see Perspectives on the Risk-Return Relationship.)
Managing Risk as a Conservative Investor
When you have a firm retirement date set, you will likely fall squarely into the conservative investor category. You no longer want the risk of losing large portions of your account, but you still need some risk to grow faster than inflation.
Your allocation will change to between 20 and 40 percent equities. These equities will be almost all large cap (and probably those that pay dividends) to keep the volatility down. Your risk profile changes from the risk of losing money to the risk of your account not growing fast enough. Without the aggressive equities, your account grows more slowly, but it doesn’t drop as much during recessions.
Fortunately, by this period your other life expenses should be minimized (house paid off, school loans gone, kids through college) and you can dedicate more of your income to your investments.
Managing Risk as a Very Conservative Investor
By the time you are within a few years of retirement, your account should become very conservative. You will want very little risk, and your goal may be to simply preserve your money rather than to grow it. You will have things arranged so you can keep up with inflation instead of growing your account.
To essentially negate risk, your account will be up to 20 percent equities. You will want to have several years worth of income invested in cash equivalents (a CD ladder is great for this). The reasoning is that you need to eliminate the risk of a three- to five-year market downturn. You don’t want to draw on your investments when the market is at a low, so during the years it is declining, and subsequently climbing, you pay living expenses from cash savings. When the market has recovered, then you can withdraw funds to replenish your depleted cash sources.
Your most conservative years will be the five before retirement through the five following retirement. During these years, you can’t afford to lose money while you figure out your retirement lifestyle and income needs. After a few years of retirement, you can actually start to take on more risk. Keep in mind that by the age of 80 you likely won’t be spending as much.
The Bottom Line
How much risk you are willing to take is the key to building a portfolio that will meet your needs, but you can’t just assess this once. Every year or two you should re-evaluate your risk tolerance. Then, you should continue to adjust your portfolio as necessary to keep it in line with your risk tolerance.
Everyone’s goals are going to be different, so while these tips for managing risk will work for most people, they won’t work for everyone. Some will want to be more hands on; others will want to be more hands off. Find an investment strategy that is right for you, then make it a point to base your investments on logic rather than emotion.
(For more, see Investopedia's Introduction to Risk Management.)