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What Does It Take to Embrace Risk in Investing?

Cortney R Giles, CFP® |

What Does It Take to Embrace Risk in Investing?

The balance between risk and reward is fundamental to any investment strategy. However, risk can mean different things to different people. While taking on risk is essential for achieving higher returns, it can also lead to anxiety and sleepless nights. Finding the right balance that suits your personal needs is crucial.

So, how much risk are you willing to accept to achieve your goals while still sleeping soundly at night? Understanding your risk tolerance is a vital first step. It serves as a cornerstone of your investment plan and helps in crafting a portfolio that aligns with your goals.

Determining your risk tolerance isn't straightforward, but asking yourself these three key questions can help guide you:

1. What Are Your Goals and Time Horizon?

Risk tolerance is not just about your emotional comfort level; it’s also determined by your financial goals and the timeline for achieving them.

Consider your specific investment goals. Beyond long-term objectives like retirement, you may have shorter-term goals, such as funding a child’s education or saving for a home down payment. When do you want to achieve each of these goals? This is your time horizon.

The longer your time horizon, the more risk you can afford to take since you have time to weather short-term market fluctuations. For short-term goals, it’s generally wise to be more conservative, ensuring that funds earmarked for imminent needs are in low-risk, liquid assets. For example, if your child is close to college, you may want to ensure their 529 plan has sufficient low-risk funds to cover tuition in the coming years.

2. What Is Your Risk Capacity?

Risk capacity refers to your practical ability to take on risk, influenced by factors such as savings, financial obligations, income, and job security. The more financially stable you are, the more risk you might be able to take. However, if significant investment losses would jeopardize your ability to cover living expenses, pay off debt, or achieve short-term goals, your risk capacity is likely lower.

Your risk capacity can evolve over time. For example, a salary increase or paying off significant debts, like a mortgage, could enhance your capacity for risk. Conversely, losing a job or incurring new debt could reduce it.

3. What Is Your Risk Composure?

While financial capacity is crucial, so is your emotional capacity to handle risk. Few people enjoy seeing their investments drop in value, but how well can you manage these feelings? This is your risk composure.

You might be enthusiastic about taking on more risk for the chance of higher returns, or the thought may cause significant stress. Understanding your emotional reaction to risk is essential to avoid constant worry over your portfolio.

Consider how you might (actually) react during a market downturn. Will you stick to your long-term plan, or will the temptation to sell at a loss be too strong? Behavioral biases often interfere with rational risk assessment. Recognizing these biases can help you mitigate their effects:

  • Loss aversion: Losses tend to have a greater emotional impact than equivalent gains. Therefore, we often feel the pain of losses more intensely than the pleasure of equivalent gains. This response can lead to overly cautious investment behavior, causing you to miss out on the potential for greater gains.
  • Recency bias: The media makes it easy to get fixated on negative news stories at any given moment, causing us to lose sight of long-term market trends. It’s no surprise that people get hung up on this and forget the powerful effects of the market over the long term.
  • Herd mentality: People tend to follow the crowd, assuming that it must be a good idea if many people are doing something. For instance, following the crowd can lead to poor decisions, such as selling off investments in a downturn, which could hinder your ability to reach long-term goals.

Crafting Your Risk Profile

Everyone has a unique relationship with money and distinct goals, time horizons, and financial circumstances. Together, we can explore these factors to determine the appropriate level of risk for your portfolio. We’ll help you develop an investment strategy that balances risk and reward, helping you achieve your goals while maintaining peace of mind.

If you have any questions about your personalized risk profile, please contact us so we can review it together.

Untill next time, Happy Planning! 

Cort