Do you love hot and spicy foods? How about roller coasters? Maybe you prefer bland comfort foods and a good book. Of course, neither preference is right or wrong. It’s just a matter of knowing what works for you.
The same can be said of risk tolerance in your investments. Some people will be happy to day trade penny stocks while others will stick mostly to cash and CDs. Obviously, those examples are extremes, and the vast majority of us will fit somewhere between the two.
Allocation, Allocation, Allocation
When you’re investing, your risk tolerance will determine your asset allocation, or the percentage of money you put into the different asset classes. There is some debate over what qualifies as an asset class. Some people include real estate, commodities, and more sophisticated vehicles like options and futures in their mix. For our purposes, we’ll stick to the three main asset classes: cash, bonds, and stocks.
Cash is generally considered the least risky, with bonds coming next, and stocks in the most risky category. While this order of risk is quite widely accepted, it’s important to note that there is some disagreement over just how much risk each presents. Some would say cash is riskier than it appears because its value can be eroded by inflation. Others would point out that bonds might not be as safe as you think, depending on whether you hold individual bonds or bond mutual funds.
It’s also important to point out that you can have different allocations within each major asset class. Your stock allocation might include further diversification according to country, market capitalization, dividend yield, growth, value, or any number of relevant metrics. You can see that there are almost limitless asset combinations. For now, however, let’s stick to the basics.
3 Sample Portfolios
Let’s look at some examples of high-, medium-, and low-risk asset allocations. There are no hard and fast rules on this, and you can feel free to adjust according to your risk appetite. You can think of these options the way you might look at menu items at a restaurant, with the spiciest dishes highlighted by 2 or 3 little hot peppers and milder dishes with no peppers.
Note that cash can mean anything from bills in a box somewhere to money in a savings account or CD. It should be something you can easily access if you need it. Bonds can include individual bonds, ETFs, or mutual funds. Stocks may be specific company stocks, mutual funds, or ETFs.
Mild Risk Appetite
- Cash: 35%
- Bonds: 40%
- Stocks: 25%
Medium Risk Appetite
- Cash: 10%
- Bonds: 40%
- Stocks: 50%
Spicy Risk Appetite
- Cash: 5%
- Bonds: 20%
- Stocks: 75%
Again, these allocations aren’t set in stone. You can (and should) adjust them to fit your unique financial situation according to your life stage, income stability, and overall risk profile.
Age and Risk Appetite
I studied aging in a psychology course years ago, I remember hearing that as we age, we tend to choose foods that are less spicy. In general, the same is true for investment risk appetite. Most people should gradually reduce their risk tolerance as they near retirement. Normally, this means shifting some assets out of stocks and into bonds and cash.
Still, I know some people in their 20s who can’t stomach spicy foods, and some people in their 60s who enjoy those 4-pepper “suicide” dishes. Similarly, a good part of your investment risk appetite will be determined by your personality. If you’re naturally risk-averse and your portfolio is too heavily weighted in equities, you may find investing more stressful than rewarding. This could, in turn, lead you to panic and sell out of your positions at just the wrong moment.
Having said that, it’s not wise for those at either age extreme to veer too far from the standard risk appetite dictated by their age. Many people who were close to retirement when the stock market crashed in 2008 were too heavily weighted in stocks and found that they only had a few years to make up substantial losses. Conversely, some of the 20-somethings who witnessed the crash may have lowered their equity allocation so much that they could be forfeiting the higher returns that stocks can potentially deliver over time.
A Balanced Approach
When you’re trying to figure out how much of your money to put into each asset class, it’s wise to try to strike a balance between the risk appetite determined by your age and the one determined by your personality. In general, people between 20 and 40 can afford a pretty spicy portfolio. Those between 40 and 60 will want to transition into a medium-risk allocation, and those who are within a few years of retirement should think about a milder mix.
It’s also important to remember to periodically re-balance your portfolio in order to maintain your preferred asset allocation. If your stock positions have risen enough that they are taking up a larger amount of your portfolio, you’ll need to sell some of them and buy more of your lagging asset classes. That way, if your stocks subsequently decline, you’ll have cash at the ready to buy more the next time you review and re-balance your portfolio.
What’s your risk appetite? Do you like your asset allocation spicy or mild?
(photo credit: Shutterstock)
