While we can do a great deal to manage risk, we cannot eliminate it. Nor would we want to, for risk is related to expected return. In any investment plan, it is important to recognize and appropriately manage the types and the amount of risk you are taking. This will likely increase your ability to adhere to your long-term investment plan, which serves as your roadmap to guide you toward your financial goals.
The right level of risk for you depends on both your personal preferences and your situation. We break the risk equation into the following three areas:
Your risk tolerance describes your level of comfort and ability to wait through market downturns. If you can tolerate the risk, then you will be able to maintain your investment strategy through both strong markets and weak ones, and remain true to your long-term vision. If the risk is causing you to lose sleep at night, it may cause you to abandon your carefully crafted plan.
Designing an appropriate investment strategy requires balancing factors that can be in conflict. Your tolerance for risk may be high, but as a prudent investor you should also consider your ability to withstand financial losses. Because market downturns are unpredictable, you need to assess the real economic harm you might face if your portfolio declined for an extended period of time:
- How would this impact your ability to remain adherent to your long-term investment plan;
- What measures would you take (such as postponing retirement or saving more) to make up for the downturn;
- Would you have the time to withstand the decline if required to do so; and
- What are your sources of income?
Most investors would not choose to take more risk than is necessary. While this is a simple statement, investors often fail to build this concept into their portfolio planning.
An investors need to take risk is directly tied to their rate-of-return objective. This could mean, for example, retiring later, subjecting yourself to the possible discomfort of greater risk, lowering future consumption or net worth expectations, or increasing your savings.
It is our responsibility to determine whether or not investors are being adequately compensated for the risks that lurk within their portfolio. At Next Generation Wealth Management, the management of our clients risk is of paramount importance. For this reason, we believe that limiting the downside in markets that do not adequately compensate investors for the risks they must assume, is more important than speculating on potential short-term gains in the face of negative long-term fundamentals. We do not have the ability to impact market returns; however, we can construct an investment strategy with lower exposure to market volatility.