When it comes to long-term investing, the numbers are simply one piece of an enormous puzzle. The remaining pieces of that puzzle consist of your “why.”
- Why are you investing in the first place?
- Are you building up your nest egg for emergencies or unexpected expenses?
- Are you preparing to send your kids to school?
- Is it finally time to start chipping away at the downpayment on your dream vacation home?
With every vital goal comes a great deal of emotion and attachment. These emotions can often cloud your judgment and make it more challenging to see past the here and now.
How can you create an investment strategy that both your head and your heart can agree on?
Build a Comprehensive Risk Management Strategy
At Chladek Wealth, we firmly believe that risk management is more important than investment returns.
Protecting yourself and your money is an integral component of our philosophy. While investing always comes with risk, we believe your portfolio strategy should insulate you from adverse outcomes that you are either uncomfortable with or unable to handle financially as an investor.
How exactly do you deploy proper risk management?
Set Timely Goals
Before you can invest, you must understand the purpose of your money. In other words, what is this investment going to help you achieve? Additionally, when would you like to accomplish this goal? For example, you may want to retire in 15 years or buy a vacation home in 10 years.
Understand Your Risk Tolerance & Risk Capacity
Your “tolerance” for risk is your willingness to handle uncertainty. This metric is not to be confused with your “capacity” for risk (the risk you must take to reach your investment goals).
Risk tolerance is all about emotions. Regardless of their financial circumstances, investors will have varying levels of risk that often stem from their knowledge of financial markets and their historical relationship with uncertainty.
Risk capacity is simply a numbers game. A more analytical person may have a risk tolerance and risk capacity that closely align, while a more emotional person may have a considerable spread between the two.
Diversify Your Portfolio
Put simply, do not put all of your eggs in one basket. Proper diversification will spread your investments across different,
- Asset classes (stocks and bonds),
- Geographical areas (the U.S. and international), and
- Sectors (technology, energy, healthcare, etc.).
Diversification will help you decrease concentration risk (the risk that any one company, sector, or country will perform poorly).
Discover Your Risk Tolerance
Risk tolerance is a crucial metric that far too many investors (and even advisors) overlook. Ask yourself, how much risk can you actually stomach? If the stock market (and your portfolio) dropped 20% next month, how would you feel? What amount of money would you be comfortable losing at a given time?
Your risk tolerance is simply a tool to help create the best allocations for your portfolio (aka the types of securities you should invest in). Let’s review an example of how your portfolio could change based on your risk tolerance.
- Assume you require a 3% annual return on your investments to meet your early retirement goal in 15 years.
- Let’s also assume that a portfolio consisting of 100% equities (aka company stock) has a 15 year expected return of 10%. A portfolio with 60% equities and 40% bonds has an expected return of 6% over that same period.
- An extremely risk-averse investor may elect the portfolio with only 60% equities because they can not emotionally handle large fluctuations in their portfolio. The expected return of 6% still allows them to meet their retirement goals. Would a 10% return be nice? Of course. Would a good night’s sleep over the next 15 years be better? We sure think so.
Know Your Risk Capacity
As we have already discussed, risk capacity represents the amount of risk you must take to reach your goals. Perhaps your risk tolerance is extremely low, but your risk capacity is high. If you want to retire early, you likely won’t get there by investing solely in savings bonds.
In many cases, investors who more clearly understand the purpose of their investments (i.e., understanding their “why”) have an easier time aligning their risk tolerance with their risk capacity.
Your goals, risk capacity, and risk tolerance must mesh together to create an investment strategy that will lead to success over long periods.
Your Investments Will Always Have Risk, Here’s Where You Take Control
In many ways, risk is a volatile and uncertain factor. With that said, you still have a certain degree of control over how much risk you’d like to see in your portfolio.
At Chladek Wealth, we work with you to strike the right balance between risk and reward while always protecting your assets with customized risk management strategies. Risk will always accompany investing, but we can empower you to control your money, build wealth, and reach your goals.
Wondering if your portfolio aligns with your risk tolerance and risk capacity? Schedule a call with us today and let us help you craft a portfolio that is built for YOU.
The contents of this article are for general information and educational purposes and should not be construed as specific investment, financial planning, tax, accounting, or legal advice. Please consult with a professional advisor before taking any action based on the contents of this article. All investment and financial planning strategies involve risk of loss that you should be prepared to bear. We cannot guarantee any investment performance whatsoever, and past performance is not indicative of potential future returns.