Risk Tolerance for Investing

These days, I’m not much of a risk-taker. How about you?

The gutter on the south side of my barn is clogged with eucalyptus bark, leaves, and wildfire ash. At the bottom of a slanted tin roof 20 feet off the ground, it’s not easily accessible.

In the past, I’d scurry up my tallest ladder to the top and awkwardly reach around and down with my red gutter scooper while hanging onto a rung with the other hand. I’d clean a few feet, climb back down, scoot the ladder, and repeat around 10 times down the gutter’s length.

Adding even more danger to the task was the thought, even though I knew it was highly unlikely, of several dozen bats suddenly swarming about my head while hanging in that perilous position. In the above picture, you can see 3 of the bat houses I made for them hanging on the wall, which are occupied by varying populations of Mexican Freetails depending on the season.

When I was younger, stronger, and more agile, I knew if I was careful, I wouldn’t fall, even in the event of a bat attack. It’s different now. The vision of falling that distance onto hard asphalt makes my titanium joint replacements tingle. It’s a risk I’m no longer willing to take. If only I had used that strength and agility to install gutter covers!

Risk Tolerance for Investing

Risky investments like stocks have been setting record highs recently. Even so, I’m glad I’ve cut back on the percentage of risky investments I own now that I’m older. Like dangling from a high ladder, my days of investing all my money in risky investments are over, given my age (66) and current risk tolerance.

Finding your risk tolerance for investing and determining your time horizon for investment is fundamental to forging your customized investment plan. A common mistake is making your investment plan too risky. There’s a chance you won’t stick with that more aggressive plan during the next big market downturn and bale out of those risky investments at the worst possible time.

Even worse, if you’re older like me and were depending on those risky investments for living expenses and there’s a “bat attack,” now you’ve got serious trouble.

Like falling off a ladder, you might be forced to sell off a risky investment at a loss to cover expenses or worse, run out of money before it’s all over. That’s why, if you’re near or in retirement, your risky investment percentage needs to be lower than it used to be, thus boosting the percentage of safer and more liquid not-so-risky investments.

Take a Risk Tolerance Survey        

One way to assess your risk tolerance for investing is to take a quiz. I’ve found most of them, which are ubiquitous online, unhelpful, and some even silly. Use them as a starting point and resource but never rely solely on their outcomes:

Play the What-If Game

Pretend you’re age 35 and just implemented your new investment plan for financial independence with an aggressive 90% investment in stocks. Over the next month, there’s a steep stock market decline of 40%.

Are you going to leave that investment plan alone and continue to follow it? Are you going to double down and scrounge around for even more capital to invest? Or are you going to bail to try and stop the bleeding?

Losing almost half your investments in the blink of an eye is unthinkable to some. If that’s your mindset, reconsider your risky investment percentages accordingly. Another big contraction, whether caused by a bubble, pandemic, war, or some other yet unknown peril could be right around the corner. Nobody knows for sure.

Aggressive Investors

Aggressive investors must accept the ups and downs of risky markets and the occasional bubble, with an outlook that in the end, a higher per-year return will prevail. The longer your time horizon for investment, the bigger your risky percentage should be. This is true whether you’re a super-aggressive investor, ultra-conservative, or somewhere in between.

Conservative Investors

Conservative investors are much more sensitive to volatility and less confident markets will behave as they have in the past. They’re more concerned with the preservation of capital than with double-digit yearly returns.

No matter your risk tolerance for investment, your percentage of risky investments needs to shrink along with your time horizon, giving more room for not-so-risky investments.

Inflation Risk

The problem with not-so-risky investments is that many of them, because of their relative safety, earn a rate of return below the rate of inflation. That means even though your principal is secure, you’re still figuratively losing money because those dollars don’t buy what they used to.

To guard against this inflation risk, more conservative investors, especially early on, must force themselves to take on some risky investments in the hope of at the very least breaking even.

Sticking to Your Plan

As an individual investor, sticking to your plan as the sky is falling can be hard to do, but your future investing success depends on it! That’s why it’s so important to incorporate your risk tolerance into your investment plan.

Whether a more conservative portfolio wins out in the future, or stocks continue to outperform is anyone’s guess. No one can predict what will happen, but you can construct customized investment plans suitable to both your risk tolerance and time horizon.

Risk Management Strategies

What’s your risk tolerance for investing? Use your answer, along with your time horizon, to determine your ideal risky to not-so-risky mix. Unfortunately, I can’t tell you what your ideal mix should be without more of your financial details.

I can, however, based on my experience and education, give you a range of risky ratios, from very conservative to aggressive, based on your age and retirement date of age 65. More than likely, your ideal risky ratio lies somewhere in between the two extremes:

Risk can’t be eliminated from your investment plan. It can, however, be managed.

To help you manage your plan more effectively and economically, I’ve developed 3 risk management strategies to help you do it yourself. I suggest you incorporate all of them into your investment plan for the best results.

Risky to Not-So-Risky Ratio

By referencing the above % of Risky Assets chart, you’ve already determined your ratio for year 1 of your investment plan. (To calculate your not-so-risky percentage, subtract your chosen risky percentage from 100.)

Next, calculate your risky to not-so-risky ratios for the remaining years of the plan. Keep the following in mind:

  • The longer your time horizon and the higher your risk tolerance for investing, the closer you want to be to the riskiest of all ratios, a 100-0 risky to not-so-risky ratio.
  • The shorter your time horizon and the lower your risk tolerance for investing, the closer you want to be to a 0-100 risky to not-so-risky ratio.
  • Your investment plan should never have a riskier ratio next year than you had the previous year: Your ratio should either stay the same or shift to less risky because of your ever-decreasing time horizon for investment.

Dynamic Diversification

Diversification on the risky side of your ratio means including different types of stocks and other risky investments with varying degrees of risk. This could include value and growth elements, international, and varying market capitalizations. The dynamic in dynamic diversification means gradually shifting the riskiest parts of your risky side to less risky investments before crossing over to the not-so-risky side.

Risky investments have different degrees of risk. An investment in emerging international markets, a small-cap domestic stock, or crypto currency is way riskier than an S&P 500 Index Fund, for example. It’s not that you can’t lose money with that S&P 500 index fund. You can still lose your shirt. However, with those riskier investments, you could lose your shirt and your pants.

Like risky investments, not-so-risky investments have different degrees of risk too. Fixed-income investments face two types of risk: Business risk and interest rate risk. A fixed-income investment with a large degree of both business and interest rate risk is much riskier and potentially more profitable than one with lesser risk.

What combination of risky to not-so-risky ratios and dynamic diversification will produce the best results? Only time will tell. Find your place among the various possible combinations. Mess with your allocations until they feel just right.

Rebalance and Reassess

Did you know that past Best Money Newsletters, including last month’s deep dive into the importance of rebalancing and reassessing (the last of my 3 risk management strategies), can be found at my keithdorney.com website?