By Jorie Pitt
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Investing does not need to be complicated. All you need is a little bit of knowledge and a well-thought-out plan. One important step, however, is often overlooked in the building of an investment portfolio. This is taking the time to really consider the asset allocation that best fits your unique situation.
Asset allocation is the determination of how much of your portfolio should be invested in cash, bonds and stocks. The more that you invest in stocks, the higher the rate of return you could expect over time. However, a higher allocation to stock will also cause your investment portfolio to be more volatile, meaning your portfolio balance will have higher swings up and down. It is a well accepted tenet of investing that you cannot gain higher returns without accepting additional risk.
There are two considerations when choosing your asset allocation: your risk tolerance and your risk capacity.
Risk tolerance is a measure of how you deal with large swings in your investment portfolio. Ask yourself how you will feel if you wake up one morning to find that your portfolio has lost 30 percent of its value. Will you shrug it off and tell yourself that investing is a long term process and leave your portfolio in place? Or will you panic and start selling investments to stop the losses?
How you answer this question is indicative of your risk tolerance. If you have a high risk tolerance, you can handle large swings in your portfolio with a minimum amount of discomfort. If you have a low risk tolerance, large losses in your portfolio may be so painful for you that you need to sell to stop the pain.
It is important to be honest with yourself about how you will react to large losses in your portfolio because selling when the markets are down can be very detrimental to your long term portfolio returns. In effect, you may string together a pattern of buying high (when the market outlook is good) and selling low (when markets have dropped and you start to panic). In general, the lower your risk tolerance, the less stock and the more bonds you should have in your portfolio.
Risk tolerance is only one half of the asset allocation equation. You also need to consider your risk capacity. Risk capacity determines how much you can afford to lose in your portfolio. For example, a 75-year-old man may have a very high risk tolerance and not be upset over a large drop in the market. However, this same man may find that a large dip in his portfolio greatly increases the chance he could run out of money since he does not have a long time horizon in which to recover the losses. This man has a high risk tolerance but a low risk capacity.
On the other hand, you may have a 28-year-old woman who loses sleep if her portfolio loses more than 5 percent. This woman has a low risk tolerance but a high risk capacity since she potentially has 35 years to recover these losses before she will need the money. Generally, younger people have a higher risk capacity because they have a longer time horizon for their portfolios to recover.
It is important to try to harmonize your risk tolerance with your risk capacity. In the example with the 28-year-old woman, investing in a more risky portfolio just because she has a high risk capacity is going to cause her more stress than necessary. Instead of chasing higher returns by taking additional risk in her portfolio she may consider increasing the amount of money she saves each year. The compounding returns on the additional contributions will help to balance the slightly lower returns she may incur from a less risky portfolio.
The best way to determine the correct asset allocation for you is to work with a financial planner to build a financial plan. The financial planning process will help identify any divergence between your risk tolerance and risk capacity. Your financial plan will then become your road map as you implement your investment strategy. If you are not ready to build a financial plan, you will be able to find many free risk assessment calculators online. Take a few assessments to get an idea of an asset allocation that may be right for you.
Jorie Pitt, CFPR is a financial planner for AHC Advisors in St. Charles, Ill. She is a graduate of the University of Illinois, Champaign, which she attended as a Chick Evans Scholarship Recipient. Jorie has been a member of the Financial Planning Association for many years and has previously served as the chair of special events and the director of public awareness. She is excited to continue her involvement with FPA-IL in 2014 as treasurer. She can be contacted at firstname.lastname@example.org.
Financial Planning: Investing basics – risk tolerance and risk capacity
By Jorie Pitt