While few people enjoy taking risk, it’s a normal part of investing. In fact, some risk is actually beneficial and serves a valuable purpose. If investors didn’t accept some risk, there wouldn’t be the potential to achieve higher returns. However, it’s important to ensure you’re not taking on unnecessary risk. The goal is to determine what level of risk you’re comfortable accepting and then balance it with the required risk necessary to achieve your long-term goals.
|Range of Returns in the S&P 500
|Years with returns:|
|Greater than 45%||3|
|Between 30% and 45%||16|
|Between 15% and 30%||25|
|Between 5% and 15%||15|
|Between -5% and 5%||10|
|Between -15% and -5%||13|
|Between -30% and -15%||3|
|Worse than -30%||3|
Risk in the investment world is usually associated with volatility. A commonly used phrase states, “Risk and return go hand in hand,” meaning the higher the return potential, the more volatility you must be willing to accept. Markets never move in a straight line – there are ups and downs. In fact, although the stock market has averaged nearly a 10% annual return since 1926, only 15 times has it returned between 5% and 15%, and only five times has it returned between 8% and 12% in a single year. Importantly, the market has had more than twice as many up years (64) as down years (24), serving as a reward to those long-term investors who can handle shorter-term volatility.
Overall, individuals face many other types of investment risk, such as interest rate risk, credit risk, economic risk and currency risk. Investors, meanwhile, often define risk as the potential for loss.
Source: Ibbotson. Total return including dividends. Past performance does not guarantee future results.
At its most basic level, risk refers to uncertainty and is much broader than volatility and the potential for (and size of) losses. Perhaps the biggest risk you may face is not reaching your financial goals. For example, a portfolio that is all in cash may have little, if any, volatility, but it also won’t provide any growth potential or inflation protection. For retirees, not keeping up with inflation, or not having the right withdrawal strategy, can lead to another major risk: the risk of outliving their money. Ultimately, the key is to determine what level of risk is appropriate to help you achieve your goals.
While risk may come in many forms, the process of determining what level of risk you’re comfortable with covers three main areas:
Risk Tolerance – This refers to your willingness or comfort level with taking risk. Typically, you’ll be asked to complete a questionnaire that’s used to gauge how you might react to risk in different situations. Gauging risk tolerance and your potential behavior is important because it’s unlikely you’ll reach your long-term goals if you abandon your strategy due to short-term market volatility. By finding the right balance between the risk you’re willing to accept and the returns you anticipate receiving, you’ll be in a better position to stick with your investment strategy regardless of what the market is doing.
Risk Capacity – While risk tolerance refers to your comfort level with risk, risk capacity considers your ability to handle risk. Your investment time horizon is often one of the biggest factors in determining your risk capacity. For example, if you’re younger and saving for retirement, you have a long time to make up for losses and could reasonably handle more volatility. However, if you’re retired, your ability to handle volatility will likely be less. Aside from your time horizon, other items, such as income needs, may influence your risk capacity. For example, investors with a large amount of fixed expenses may not be able to tolerate much volatility, given their income needs. On the other hand, an investor with more discretionary income who isn’t depending on the account for income may have a much greater ability to handle volatility.
Required Risk – This refers to the level of risk that is necessary, or required, to achieve your investment goals. As shown in the chart below, the higher the return necessary to reach your goals, the more potential risk you’ll need to take on to achieve them. As you discuss your goals with your Edward Jones financial advisor, together you can determine the asset allocation, or mix of different types of investments, necessary to help achieve those goals, as well as the associated risk profile of each asset allocation.
The next step is really a balancing act, as sometimes there is a discrepancy between how much risk you are comfortable taking and how much you actually have to take to achieve your goals. This is where you may need to make some important decisions. Your financial advisor can help you build a portfolio that balances your risk tolerance and capacity with your investment goals and the required risk necessary to achieve them. For example, suppose you want to retire at age 55, and you have a low risk tolerance. However, your financial advisor estimates that to accomplish this goal, you will need a higher return, resulting in a higher degree of portfolio volatility. In this case, you may have several choices, including working longer, saving more or accepting a higher degree of volatility. While this is a personal decision, by better understanding your goals, and the risks associated with achieving them, you can make a more informed decision.
Typically, what prevents most investors from reaching their goals is not market volatility itself, but the investor’s reaction to this volatility. Investing based on emotions can often lead to one lasting emotion: disappointment. For example, according to a recent DALBAR study, from Jan. 1, 1994, through Dec. 31, 2013, the average investor’s portfolio performed much worse than the S&P 500. It’s not because people owned the “wrong investments,” but because they chased performance, buying when investments were up and then selling when they dropped in value.
Understanding your comfort level with risk can only make you a better investor and perhaps avoid some of the pitfalls shown in the chart above. By knowing your risk tolerance in advance, you can better control your emotions and stick to your long-term strategy during the inevitable bumps along the way. In addition, adhering to sound investment principles, such as diversifying among quality investments and holding them for the long term, can be critical to managing risk and achieving your long-term success. It’s important to discuss with your financial advisor your goals and the amount of risk you’re willing to take to reach them. You may need to make some difficult decisions. But ultimately, these decisions may help you avoid the biggest risk you face: not reaching your financial goals.
Past performance does not guarantee future results.
The S&P 500 is an unmanaged index and cannot be invested into directly. Diversification does not guarantee a profit or protect against loss.