Seek to balance ‘risk tolerance’ and ‘required risk’
December 18, 2014
Like everyone else, you have financial goals. To help achieve these goals, you may need to invest — and when you invest, you'll need to take on some risk. But the more you understand this risk, and the better you are at managing it, the greater your potential for staying invested for the long term.
To begin with, then, take a look at these terms:
Risk tolerance — Your risk tolerance is essentially your comfort level with taking risk. For example, if you have a high tolerance for risk, you may be comfortable investing aggressively. Conversely, if you tend to be risk-averse, you might lean more toward more conservative investment vehicles that offer greater protection of principal.
Required risk — While the term "required risk" may sound odd, it is actually an integral component of your ability to invest successfully. Basically, your required risk is the level of risk necessary to help you achieve your investment goals. The higher the return necessary to reach those goals, the more potential risk you'll need to assume.
As you invest, you'll need to balance these two aspects of risk. For example, what might happen if you have a low risk tolerance, leading you toward "safer," low-growth investments, but your goal is to retire early? For most people, this goal requires them to invest in vehicles that offer significant growth potential, such as stocks. And, as you know, investing in stocks entails risk — specifically, the risk that your stocks will lose value. So in this situation, your risk tolerance — the fact that you are risk-averse — is going to collide with your required risk level, the amount of risk you are going to need to take (by investing in stocks) to achieve your goal of early retirement.
When such a collision occurs, you have two choices. First, you could "stretch" your risk tolerance and accept the need to take on riskier investments in exchange for the growth potential you will require. Your other choice is to stay within your risk tolerance and adjust your ultimate goal — which, in this example, may mean accepting a later retirement date.
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But if you have many decades to go until you retire, you actually do have time to recover from short-term losses, which means you may be able to reasonably handle more volatility. In any case, by balancing your risk tolerance and your required risk level — and by understanding your risk capacity — you can be better prepared to take the emotion out of investing. When investors let their emotions get the better of them, they can make mistakes such as chasing "hot" stocks or selling quality investments due to temporary price drops. By having a clear sense of what risk really entails, however, you may be able to avoid costly detours — and stick with your long-term investment strategy.
Doug Drost is a certified financial planner for Edward Jones, 2262 Reno Highway.
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