Age
Age is one of the most critical factors for decision-making on any level. In general, young people tend to take many more risks. When working for a financial institution, I always advised younger (21-30) professionals and graduates to choose the riskiest portfolio possible all while increasing their investment knowledge. It will be very practical in the future. Time value of money is a powerful tool to use over the course of life.
Usually, there are very few major expenses in the immediate future for investors under 30, which makes more risk tolerable; example would be advising clients closer to retirement to stick with more conservative allocations for their investments. Therefore, it becomes important to preserve capital for daily expenses.
Family
Family is an important factor when making a decision. It’s important to think about children and spouses and to make the right decisions for their best interests. Once again, younger investors are less likely to have a family in their 20s. Hence, they can make riskier decisions. Families with children will usually play it safer. They want to save money for education, holidays, and a house.
Goals
Different investment goals have different risk strategies. For example, investors with short-term goals, such as holidays, repairs, or small purchases, should opt for relatively safe investments to preserve capital.
However, a 20-year-old who wants to buy a property at age 35 should risk much more to reach their objective sooner and switch to safer investments.
Portfolio Size and Psychological Comfort
The difference in risk between an investor with a portfolio over $1M and one with 10K In most cases, is risk tolerance. Generally speaking when investing for smaller portfolio leads to less risk; however this is not always the case. Investors with smaller incomes will risk less because of less capital. On the other hand, wealthier investors can take more risks.
When I worked for a financial institution, we had a questionnaire for clients who wanted to invest in mutual funds ,stocks, bonds, or whatever investment vehicle being used. Many of the questions addressed how much an investor could tolerate losing in a set time frame. Many new and experienced investors cannot stand to see their portfolios losing value even if the funds are not necessary anytime soon.
After the questionnaire, I could place my clients into their appropriate portfolios. Each had a different risk tolerance. In the next section, we will explore them.
Types of Risk Tolerance
Many financial institutions will offer mutual funds with varying degrees of risk. They often give them comfortable and reassuring names to make their clients feel more secure. After completing the questionnaire, they are offered an option that fills their needs. Below, we will examine the three most common portfolios and their characteristics.
Conservative
Investors who choose a conservative portfolio have a low tolerance risk. They prefer to see their portfolio grow slowly over time instead of seeing periods of high volatility. As a result, conservative investors tend to be closer to retirement and with a smaller portfolio balance. Often, they rely on the expertise of their financial advisor to perform trades.
A conservative portfolio comprises 10-20% bonds and 80-90% stocks. The latter are usually domestic and have a proven track record. Financial institutions are an excellent example of a stock in this portfolio. An investor can expect an average return of 3-5% annually; however nothing is certain; these are just estimates and the actual return is set to fluctuate throughout the invest period.
Moderate/Balanced
A moderate/balanced portfolio is when investors are comfortable with more risk but want to remain balanced in their portfolio allocations. This portfolio applies to investors of all ages and social statuses.
A typical balanced portfolio holds 30-40% of bonds. The remainder is in local and domestic stocks. New sectors can be introduced. The average yearly rate of return often has a target of between 6-10%.
Aggressive
The aggressive portfolio is often suggested/choosen by younger investors that have more time on their hands to hit their goals. This would be an account where let’s say the client wants to save/earn enough for a down payment on a new house. Investors who want a high level of risk choose this type of portfolio. Aggressive investors usually have a deeper knowledge of investments. They rarely use financial institutions’ investments such as mutual funds, Guaranteed Investment Certificates (GICs), or savings accounts. Instead, they have their brokerage account and perform their trades.
An aggressive portfolio can hold a wide range of stocks or a single sector, such as tech, utilities, growth, dividends, and small/mid/large-cap stocks. The portfolio contains little to no bonds. Returns and losses can both vary from year to year. With more risk the client understands that if the market is in a downtrend this could result in a down year or so depending on market conditions. However this account is great for down markets as well if used in conjunction with Dollar Cost Averaging can be a great way to get higher priced equities on clearance.
How to Spread Risk Across Investments
The saying “Don’t put all your eggs in the same basket” has been around for a long time and can be used when talking about investing. Diversification is key; which means spreading your allocations across different sectors and not just equities from one sector. An example would be having a mix of sectors from banking, tech, biotech, marijuana, textiles, and/or maybe even some written contracts on some options to generate premium for the account. So long story short; please diversify.
How to Diversify
First, allocate your funds to more than one industry or type of investment. There are 11 sectors to choose from, each with different types of industries. Many asset managers create portfolios for every niche. There is something in virtually every category, from small-cap growth stocks to commodities. In all cases, proper due diligence must always be performed.
Investors should also research if the investment aligns with their risk tolerance and strategy. Every ETF and the mutual fund has a fund fact or prospectus for investors to read. Take the time to go through this document before investing.
Other Investment Categories
Stocks, mutual funds, and ETFs are not the only investments available. In some cultures, investing in real estate, which is something tangible, is an excellent practice. In the last few decades, property prices have seen a huge boom. As the population keeps growing and moving into cities, the number of properties will keep increasing. Prices might also keep increasing, but there might also be a correction. It is hard to predict, but in any case, a real estate is often a good option.
In some countries, being an accredited investor might open new doors. They have access to alternative investment vehicles. They come with more risk but also more reward. Once again, it is important to be knowledgeable and perform DD and do research before embarking on this journey.
Risk Tolerance Final Thoughts
To conclude, every investor has a different level of risk they are willing to undertake. Fortunately, there exist different types of risk categories. Beginners can visit their local financial institutions for help, while experts can manage their investments with the help of a broker. It is important to understand how much risk to take, set up a strategy, and follow it.
Finally, diversification is an important part of investing and reducing risk. Many investment vehicles exist, and investors should expand their knowledge of them.
