Your portfolio should reflect your risk tolerance.
How many times have you heard this tidbit of advice and wondered if you were overexposed, underexposed or exactly where you should be when it comes to investment risk?
Certainly, it makes sense that your investments should match your ability (financially) and willingness (emotionally) to stomach large swings in the market. But how are you supposed to know what your personal risk tolerance is? Unless you’ve experienced an extreme high or low as an investor, it’s hard to know how you’ll react. Even those who were hurt badly in 2000 and 2008 are finding it difficult to control the greed or fear that current market conditions can evoke.
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Labeling Yourself as ‘Conservative’ Just Doesn’t Cut It
For those nearing retirement, there’s the general guideline that you should have less risk as you get closer to needing your nest egg. But that, too, is an awfully broad concept. And we’ve learned that popular terms like “conservative,” “moderate” and “aggressive” can be misleading. (A 60-year-old’s idea of moderate investing, for example, may be far different than a 35-year-old’s perspective.)
The good news is that investors now can better define their individual risk tolerance through a process that assigns them a “risk number” instead of a subjective term or an estimate based on a brief conversation. The process starts with an in-depth questionnaire that helps determine how much investment risk a person is comfortable with taking in order to obtain a potentially larger financial reward. And it’s based on decades of work in behavior economics, including “prospect theory,” which earned American psychologist and economist Daniel Kahneman the Nobel Memorial Prize in Economics in 2002.
Find Out What Your Risk Number Is Instead
What is a risk-number profile? A risk-number profile typically looks at the level of risk an individual can afford to take, the risk he or she prefers to take, and the amount of risk that might be required to achieve the person’s goals. The process used to determine your risk-number spots patterns in the answers and assigns a risk number somewhere on a scale from zero to 100. That number can then be used to determine whether the investor’s current portfolio is a match, how it would stand up under various market conditions, and what, if anything, should be changed to make it a better fit.
Just as significantly, it can help informed investors set realistic expectations and stay on track as they move forward.
Probably the most important thing about knowing your risk number is that it can help you stop piecemealing your portfolio. Too frequently, people pick up investments from year to year — stocks, bonds, annuities, CDs or whatever — without any plan in place. Maybe a friend told them about a killer stock, so they bought in. Then they read that exchange-traded funds (ETFs) were the best way to go, and they added those. They also signed up for the 401(k) at work without really knowing what’s in their plan, other than that they chose a 60/40 or 50/50 mix.
The problem is, that piecemeal approach can end up costing more in the long run than hiring a financial professional to get a comprehensive plan — one that actually suits your needs, objectively aligns with your specific goals and evolves with you.
Because this isn’t like Ron Popeil’s rotisserie oven: There’s no such thing as “set it and forget it” in financial planning. As your life changes, your investment strategies likely will have to change with it — especially as you reach retirement. Unfortunately, that’s often when people suddenly start paying closer attention to how their investments are performing, how much they’ve accumulated in their nest egg and whether it’s enough to get them through 20 to 30 years or more.
They get nervous. And that can lead to mistakes.
Risk Profiles Help During the ‘Retirement Red Zone’
Building a solid foundation can help you stick to what’s working and change what isn’t when it makes sense based on life events, instead of panicking during market dips and downturns. That’s especially critical in the five or so years leading up to retirement and the first five years into retirement — usually referred to as the “retirement red zone.” Taking a hit to your nest egg during this period, without time to recover the money, can be devastating.
The cost of living keeps increasing. So does the average life expectancy. It’s critical to have a plan that will keep providing income as long as you and your spouse need it.
That’s why I recommend working with a seasoned adviser (a fiduciary who’s looking out for your best interests) to obtain your risk profile, review it and help create a plan based on that knowledge — not a cookie-cutter portfolio that’s the same as every guy or gal who ever sat next to you at work. The information and insight a risk profile provides can help you protect your financial future.
Kim Franke-Folstad contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
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