As a general rule of thumb in investing, more risk, more potential reward. But one of the biggest fears people have when it comes to investing is losing their hard-earned money. Why take the risk when you could keep your cash safely stored in your checking account?
Well, a lot of reasons. For one, limiting the risk you take limits your returns. And when it comes to your biggest financial goals—like retiring—maximizing your returns is going to ensure you have enough saved up. Plus, because the prices of goods creep higher over time–what’s known as inflation–keeping your money in a checking account can actually mean it’s depreciating in value.
Related: Hedging Against Inflation
Hence, investors should consider their appetite and tolerance for risk, and try to determine which assets are suitable for them. Investing involves understanding the risk profiles of the different assets. For instance, stocks are more volatile and further out on the risk spectrum, but can also generate bigger returns than bonds or cash.
When it comes to asset allocation, a portfolio more heavily weighted towards stocks may be more appropriate for an investor in their 20s beginning to get into investing. Meanwhile, for an individual closer to retirement, a portfolio that has bigger weightings of bonds or cash may be more suitable.
Every investor needs to consider how much risk they’re willing to tolerate and what kind of returns they’re seeking. Here’s a closer look at how to approach these questions.
Higher Risk, Higher Potential Return
The most important thing to understand about risk is something you’ve probably heard before: The higher the risk of your investment, the greater return you should expect on your money. It is, however, the nature of risk that the return you expect might not be the return you actually get.
The concept of “Modern Portfolio Theory” emphasizes that risk and reward are linked. If you hope for a higher return, you should also expect a higher volatility—the variability of actual returns. The returns on an exchange-traded fund (ETF) may be up one year and down the next.
Returns on a mutual fund of emerging markets will likely have much wider changes in returns from year-to-year, or even month-to-month. You might make a lot more money, but you also could lose much more.
How Much Risk Should You Take?
When choosing a risk level, you want to first look at the goals you have (buying a house, saving for college, and retiring, to name a few), as well as how many years will it be before you need the money for each goal. That’s called a “time horizon.”
Generally speaking, the longer the time horizon, the more risk you can afford to take, because you have more time to recover from market downturns.
This is why young people are advised to put their retirement savings in a more aggressive portfolio—there’s a lot of time to go! As you get closer to retirement, you’ll generally want to be more conservative. Consult SoFi’s retirement calculator to see where you stand on your retirement goals.
What Types of Risk Are There?
There are several types of risk that every investor should be aware of. Here are a few:
• business specific
• price volatility
• interest rate
Some risks you can’t avoid, like market risk or beta. The market goes up and down, and this often affects all stocks. Investors can measure the risk in their stock holdings by finding their portfolio’s beta. This will show how sensitive one’s portfolio is to volatility in the market.
You can, however, reduce other risks. For example, if you buy individual stocks, you open yourself up to business specific risk. But, if you buy an index fund, you are buying assets in multiple companies. If one of these companies falters, it will impact the index, but it won’t have the same harsh impact on your investment. This is why seasoned investors emphasize portfolio diversification so much.
How Should You Manage Risk?
How do you use these concepts to manage your investing risk?
SoFi Invest®’s Automated Investing service provides five levels of risk based on your time horizon, financial goals and risk tolerance:
• Conservative: Bonds 100%
• Moderately Conservative: Stocks 30%, Bonds 70%
• Moderate: Stocks 60%, Bonds 40%
• Moderately Aggressive: Stocks 80%, Bonds 20%
• Aggressive: Stocks 100%
Each one uses a different mix of asset classes in a process called “asset allocation.” Each asset allocation attempts to find the mix of asset classes that produces the highest expected return at each level of risk. The trick is finding the one that best matches the time horizon for your goals.
For instance, the “Moderate” portfolio has 60% stocks to give you potential growth, but 40% bonds to reduce the price swings of the stocks and still give you interest income. This might be appropriate if you have a medium term goal, like buying a home or a child’s education starting in 4 to 7 years, or even when you are approaching retirement or in its early years.
An “Aggressive” portfolio has 100% stocks to maximize growth potential. If you are a younger person saving for retirement, this might be a good choice for you. You should expect this mix of assets to have much wider value swings than the first portfolio. While it will probably appreciate more in up markets, it will also drop more than the other portfolio when the market goes down.
Note that if that is going to freak you out—and cause you to sell everything and hide your money under your bed—this is not the portfolio for you!
Be honest with yourself. Over time this portfolio is more likely to have a higher return than the other one, but only if you stay invested through the bad times as well as the good. If that isn’t you, no problem—just pick a less risky asset allocation.
In investing as in life, you need to take risks to move forward. The key is to understand the nature of the risk, don’t take risks that you can’t afford, then take steps to mitigate risk and still reap the benefits. Think about it like driving a car. It’s risky, but you understand that risk and mitigate it by maintaining your car, obeying traffic laws, and buying insurance. The return is that you get where you’re going faster.
There are no guarantees in investing, but you can make an informed choice of the amount of risk you are willing to take and invest intelligently to reach your goals.
Not sure what the right investment strategy is for you? The Automated Investing service with SoFi makes it comprehensible: advisors are available to offer you complimentary, personalized advice. If you prefer a more hands-on approach and want to choose stocks, ETFs or fractional shares yourself, try the Active Investing platform.
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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.