It is well known among many investors that taking on more investment risk can lead to higher returns. While this can be true, it is important to remember that, by its nature, higher risk can also lead to higher losses. One of the best ways to position your investment portfolio for success is by finding a balance between risk and returns that is in line with your overall risk tolerance, your investment timeline, your goals for the future and any potential challenges you may face. The following tips can help.
#1 – Understand the types of risk you may face.
There are six main types of risks investors tend to face. It is important to understand the specific risks that could potentially impact you in order to take steps to reduce those risks.
- Volatility risk – Volatility risk refers to the potential changes in an investment’s value. An investment with high exposure to volatility risk will typically experience significant fluctuations in value due to market volatility.
- Liquidity risk – Liquidity risk refers to the risk that an investor may not be able to exit an investment when he/she wants. For example, many private investments do not have an open market for their shares, and exiting may be restricted by the investment agreement.
- Inflation risk – Inflation risk refers to the possibility that an investment’s returns are not enough to keep up with inflation. Over time, this risk can lead to a decrease in purchasing power.
- Interest rate risk – Interest rate risk is faced by bond investors when a change in interest rates reduces the value of a bond. Longer-term bonds are typically more sensitive to interest rate risk.
- Default risk – Default risk refers to the possibility that a borrower, such as a bond issuer, will be unable to make payments on its obligations.
- Political risk – Political risk refers to the potential risk of political events, policies and/or instability impacting an investment’s performance. This risk is also referred to as geopolitical risk.
The exact types of risk you face depend on several factors, including investment type (stock, bond, etc.), geographic region, business fundamentals, credit worthiness, etc. Your wealth advisor can help you identify and manage specific risks.
#2 – Determine your risk tolerance.
Risk tolerance refers to the amount of risk you are comfortable taking given an investment’s return potential. Risk tolerance is different for everyone. Some investors are comfortable with risk and do not mind watching their portfolio value fluctuate greatly. However, other investors are uncomfortable with risk and experience significant stress when the value of their investments drops.
Your wealth advisor will likely present a series of questions and scenarios to help determine your particular risk tolerance. This is an important step in helping you establish your investment priorities and develop a risk profile you can be comfortable with over the long term.
#3 – Articulate your investment goals.
As with all aspects of your finances, your investment decisions should be informed by your goals. Before investing, make sure you understand what your goals are. Are you investing for retirement? To purchase a home or second home? To save for a child’s college education? To become financially independent?
Your investment goals should play a key role in determining an appropriate balance of portfolio risk. Your wealth advisor can help you articulate your goals and determine a risk profile that meets your specific needs.
#4 – Understand your investment timeline.
Another important consideration in determining the right level of risk for you is your investment timeline. This refers to how long you plan to keep your money invested before you need to access it. An individual with a longer investment timeline may be able to withstand more risk than a person with a shorter investment timeline.
For example, an investor who is 20 years from retirement probably has time to ride out short-term market volatility before withdrawing assets to fund his/her retirement lifestyle. However, an investor who is five years from retirement may be forced to realize short-term losses if his/her portfolio value drops significantly in the years leading up to retirement.
#5 – Establish a target rate of return.
Once you have an understanding of your investment goals, risk tolerance and time horizon, you can establish a specific rate of return to help guide your decisions. Work with your wealth advisor to model various scenarios to gauge your likelihood of achieving your goals based on different rates of return. This process can help you determine the level of risk you should take in order to achieve your goals within your required timeline.
If you could use some help determining the right balance of risk and returns within your investment portfolio, we would love to have a conversation. To learn more about how United Capital Financial Advisors can help you plan for the future, please contact us.
