When it comes to investing, there are several types of risk. Those risks include inflation risk, market risk, political risk and interest-rate risk.
When it comes to developing and managing an investment portfolio, two of the biggest risks are risk tolerance and risk capacity. Most investors are familiar with the concept of risk tolerance. Simply stated, risk tolerance is the amount of risk an individual is “willing or take” with his or her investments. Risk capacity on the other hand is the amount risk an individual investor “needs to take” to achieve his or her financial goals.
Achieving your financial goals starts with determining an asset allocation that matches an investor’s risk tolerance and risk capacity levels.
Over the years, I have seen too many investors get into trouble because of two things: They don’t know how much risk they are taking, and they don’t know how much risk they need to take to achieve their financial goals.
When I first meet with a potential client I will ask what their current portfolio’s asset allocation is and why did you choose this specific allocation? The vast majority cannot answer these two questions.
At Capital Wealth Management, one of the ways we determine a potential client’s appropriate asset allocation is to “back-test” his or her current portfolio.
The accompanying chart shows how nine portfolios of various percentages of stocks and bonds have performed over the last 100 years. The second column shows the average return of each portfolio, and the third column shows the worst calendar year loss for each portfolio. These figures are useful because they help clients to better understand the risk/return tradeoffs and range of returns their portfolios could potentially subject them to during periods of significant stock-market gains and losses.
For example, if an investor needs to earn a return of 9% (risk capacity) to achieve their financial goals, they might consider investing in a portfolio of 70% stocks and 30% bonds. A portfolio with an allocation of 70% stocks and 30% bonds earned an average return of 9.1%. The trade-off is that this portfolio’s worst calendar year loss was minus-30.7%. If they are not comfortable (risk tolerance) with the thought of ever losing more than 10% in a given year, then this portfolio would most likely not be an appropriate allocation based on their significantly different risk capacity and risk tolerance levels.
Successful investing is a delicate balancing act between risk and return. Investors who are constantly on an emotional roller-coaster ride with their investments are almost always guilty of two things: They overestimate their risk tolerance and underestimate the risk in their portfolios.
There are many factors to consider when building an investment portfolio, and knowing what your risk tolerance and risk capacity levels are two of the most important aspects to having a successful investment plan. It doesn’t matter how high or low they are, as long as you know what they are.
Once you know your risk tolerance and risk capacity levels, you can then create an investment portfolio you can be financially, and emotionally, comfortable with through all market cycles —bear markets, bull markets and everything in between.
Martin Krikorian is president of Capital Wealth Management, a fee-only registered investment adviser at 9 Billerica Road, Chelmsford. He is the author of the investment books, “10 Chapters to Having a Successful Investment Portfolio” and the “7 Steps to Becoming a Better Investor.” Martin can be reached at 978-244-9254, Capital Wealth Managements website; www.capitalwealthmngt.com, or via email at, firstname.lastname@example.org.