Creating a portfolio that accurately reflects your risk profile helps you navigate a volatile stock market. Your risk profile drives your asset allocation which defines how investments are divided between stock and interest earning vehicles such as CDs, bonds and cash. It also defines how the stock portion of the portfolio is broken out between domestic and international funds, large, medium or small company funds and value or growth-oriented funds. Ideally you want a well-diversified portfolio that supports your unique risk profile.
A portfolio that is well aligned with your risk profile helps you avoid emotional reactions to sudden changes in the market. Too much risk causes stress and worry that often results in the sale of stock mutual funds when they are down. The goal is to set an asset allocation that takes enough risk to meet your long-term goals, while giving you peace of mind to stay the course during rough market conditions.
There are three components to your risk profile, emotional risk tolerance, capacity or ability to take risk and the need to take risk – each of which should be considered individually. Emotional risk tolerance is the ability to deal with uncertainty and aversion to loss. It’s a reflection of your ability to experience a drop in the market without significant distress. Your tolerance for risk is based on your unique experiences and values. The appropriate asset allocation should reflect your tolerance for risk with a mix that enables you to stay on track to your plan.
Generally, investors with more knowledge and experience are less risk adverse. They understand that some risk is necessary to gain higher returns and that corrections have always been followed by a rising market.
Your ability to take risk is a function of your investment timeframe, income in relation to expenses and net worth. If you have limited financial resources, you can’t afford to take much risk, regardless of your emotional risk tolerance. Funds need to be kept in safe investments to cover unexpected expenses. Additionally, if your expenses exceed income, you will need to draw on investment assets to cover living expenses. Money needed in five to seven years should be held in safe, interest earning investments. On the other hand, if you don’t plan to access your portfolio in the short term, you can take more risk because you have time to ride out fluctuations in the market and recover from major market downturns.The need for long term growth may also impact how much risk you take. If you have already amassed a large portfolio you don’t need to take a lot of risk to increase your net worth, the primary goal may be to stay ahead of inflation. On the other hand, if you are still building your retirement portfolio you need to take a reasonable amount of risk to grow the portfolio to reach your retirement goals.