8. Building an Investment Portfolio
a. Risk tolerance
Risk Tolerance is an investor's ability to handle losses in the value of his or her investment portfolio. It is important to remember the risk/reward trade off here – there is no free lunch, as they say. If you can’t handle the potential for negative returns, it will be necessary to buy low-risk investments and be satisfied with correspondingly lower potential returns. If you want higher potential returns, you must be willing and able to tolerate variation or volatility of returns – the market’s sometimes significant ups and downs.
Besides the emotional side of accepting risk, there are some more objective things to consider such as your age, your situation, the time until the investment is needed as cash for other purposes, and especially your investment experience. It is important to understand what you are investing in! If you don’t understand, either investigate until you do understand or don’t invest.
For example, a younger person who is saving for retirement can tolerate more variation of returns than can an older person who is no longer working and needs the money to live on. Why? Because the young person has time for the investments to go back up and can also work to replace the money. The retired person is no longer working and doesn’t have time to wait for the investments to go back up – they need the money now.
The same could be said for your college savings. If you are saving for college for your child who is only an infant, you have more time and may be able to tolerate more risk. On the other hand, if college is right around the corner, you cannot afford to place this money at risk.
The general rule is that money should not be invested in stocks unless you are willing to invest it for five years. This allows for market cycles to correct, but it is still no guarantee of positive returns. There are other investment choices from one to five years that are lower in both risk and in potential return.
There are lots of questionnaires available to help you understand more about your personal risk tolerance. Many people think they are “aggressive” (want high-risk investments so they can get big returns) when the market is good and “conservative” (don’t want to lose money) when the market goes bad. It is important to focus on how you feel about declines or losses in your investment money. It’s best to develop a strategy with this in mind and stick with it. The typical investor changes course just at the wrong time.
This questionnaire from our investment partner, Vanguard, may help you understand your risk tolerance.