Risk comes in many shapes and sizes. It is important to understand each of them as well as possible so that you can avoid negative results and feelings. For example, selecting investments outside of the risk you can emotionally tolerate can lead to stress and poor investment decisions; not properly assessing the risk that a fixed asset presents could mean inadvertently hurting your savings’ potential for growth and can impact your access to the funds when you need them. Worst of all, not realizing the inherent risks in the investments you choose completely removes your ability to hedge against them.
The first step any retirement saver must take is to assess his personal tolerance for risk. Risk tolerance is what determines the level of volatility you can handle in your investments. This will not only determine how much you are willing to face losing, but how much you might be able to gain.
Generally, the younger a person is, the more aggressive she can afford to be when taking on risk. She has many more years to continue working and earning money to offset losses she might experience due to her high-risk tolerance. But the older an individual gets, the less she a chance to make up for losses.
Risk tolerance breaks down into roughly four categories:
- Low risk: When you have a low-risk tolerance, it means that you would be happy to exchange very low returns for the minimal likelihood of loss and fewer fluctuations in underlying values.
- Medium risk: You are willing to sustain some potential for losses in return for a higher likelihood of gains. You are also willing to deal with moderate fluctuation in your investment’s values.
- High risk: You are comfortable with the possibility that you could lose everything because the allure
Investors who tend to watch the market compulsively may be less able to sustain this level of risk in their investments.
- Intermediate risk: Between these broad categories can be varying levels of intermediate-risk tolerance. For example, you may not have a high-risk tolerance, but you may not be quite as conservative as an individual with medium risk tolerance, putting you in between the two.
Selecting the appropriate risk tolerance will create a vital guide for your advisor. It will also let your brokerage firm flag your portfolio should the risk classification of one of your investments change and become unsuited for your tolerance. If one does, your advisor will likely discuss the reasons for that change with you and help you determine whether the position still embodies a level of risk you are comfortable with.
Assessing your personal risk tolerance is just one aspect of overall risk assessment. Next, you must evaluate the risk of the investments you consider putting your money into. In Chapter 2, we mentioned beta, which measures the volatility of a stock against the overall market. Assessing the beta of your potential stocks will help you figure out which are too aggressive for you and those that might fit your tolerance perfectly.
INVESTMENT RISKS—UNDERSTANDING BETA
Not only do your individual investments have the tendency to fluctuate in value, but the overall market does as well. Once again, we can use the example of Obama’s reelection as an example of the market as a whole reacting to a particular event and causing a swing in stock values that does not necessarily reflect the intrinsic value of the underlying companies. This systematic risk is something that every investor and every investment is exposed to, which makes it a benchmark of sorts. That’s why market risk or volatility is referred to as beta and is the ruler by which a stock’s individual volatility is measured.
Individual investors are not expected to determine the beta coefficient of the stocks or mutual funds they want to invest in. Instead, beta is determined by analysts who look at the history of a stock’s individual movement in relation to the movement of the market as a whole. From that analysis, they are able to infer the stock’s average performance in terms of its relation to the movement of the market. They will give the position a beta of one if it tends to move in equal measure with the market, a beta of less than one if it moves less aggressively than the market and a beta of more than one if it is more volatile than the market.
For example, let’s say that from 2012 to 2013 the market, as measured by the S&P 500, gains 10 percent. ABC Corporation stock during the same period has a gain of 20 percent. XYZ stock from 2012 to 2013 gains just 5 percent. If our benchmark, the S&P 500, has a beta of 1, then ABC Corporation, which did twice as well as the S&P 500, has a beta of 2. XYZ Corporation has a beta of .5 because its performance was about 50 percent of the S&P, making it roughly 50 percent less volatile.
While beta is a great way to assess the risk of a stock, if you’re bullish or bearish about the market, it can be used to attempt and predict how a position will perform. For example, if you are bullish about the market over the next year and you see a stock with a beta of 2, you may be more likely to buy the position even though the higher beta represents more volatility, because you anticipate the market to have an upswing, meaning that the volatility will work in your favor.
Of course, stocks aren’t the only investments available, and that means there are many other types of risks to look at and evaluate, such as:
- Interest rate risk
- Liquidity risk
- Inflation risk
- Credit risk
And while there is no way to create a completely risk-free investment plan for your retirement, we can certainly help put your mind at ease in knowing your financial future is on the right path.