While all investments carry some risk, different types of investments are riskier than others. We measure an investment’s risk by looking at how volatile its return has been over a period of time.
Because fund companies have no legal limit on their expenses, competition plays an important role in keeping prices in check. Still, with no set structure and the fact that some funds perform better than others, it can be difficult to see where to get the most value for your dollar. Keep and review your fund performance reports, making sure to understand what fees you’re paying and what your investments are paying.
Degrees of risk.
For simplicity, let’s look at stocks versus bonds since these classes tend to make up a large portion of many investors’ portfolios. Historically, stocks have provided much more volatile returns than bonds, so stocks are considered the riskier investment of the two. However, not all stocks offer the same amount of risk. Certain types of stocks have provided more volatility than other types of stocks in the past. For example, stocks of companies based in emerging markets such as China and India have historically provided more volatility than U.S. stocks. Additionally, stocks of smaller companies have historically provided more volatility than stocks of larger companies.
Risk and return.
Risk and return tend to go hand in hand. This is why many people want to include riskier assets in their portfolios. If an investment is more volatile and therefore has higher risk, some people are willing to own it for the possible higher returns. Conversely, a less volatile investment offers lower potential returns. To determine the correct mix of assets for your portfolio, we assess your risk tolerance, your time horizon, and your investment goals.
Risk tolerance is defined as your ability and willingness to lose some or all of your original investment, at least temporarily, in exchange for greater potential returns. More aggressive investors with a high risk tolerance are more likely to risk losing money in the short term if there’s potential for a higher return over the long term. More conservative investors with a low risk tolerance favor investments less likely to fluctuate as much in value and are therefore less likely to generate large losses. In exchange for this safety, you have to be willing to give up the potential for higher returns. More aggressive investors tend to allocate more money to stocks, which are more volatile but also offer higher potential returns. More conservative investors tend to allocate more money to bonds, which offer less volatility. In exchange for that low volatility, however, bonds offer lower potential returns.
Your time horizon is how long you plan to keep your money invested. For example, if you’re 30 years old and intend to keep your portfolio invested until you’re 60 years old, you have a very long time horizon. If, however, you have a portfolio set aside for your 15-year-old child’s college education, your time horizon is much shorter. With a longer time horizon, you may feel more comfortable taking on riskier or more volatile investments since you’re able to ride out difficult markets and economic cycles. A riskier investment that decreases significantly in value over a short period of time has a chance to recover and appreciate over a long period of time. But, if you have a short time horizon and are close to meeting your investment goal, you won’t want to risk losing a substantial amount of your investment. Your portfolio may not have time to recover short-term losses. Investors with a shorter time horizon should therefore have a larger allocation to less risky assets.
Even if you start out with a long time horizon, you’ll have to change your portfolio’s allocation as your time horizon becomes shorter. For example, you should allocate more of your portfolio to less risky assets like bonds and cash as you approach retirement, and your allocation of riskier assets like stocks should decrease.
Your investment goals also help determine the proper allocation to riskier or less risky assets. With the help of one of our advisors, you can assess how much your portfolio needs to grow to meet your goals. If more growth is needed, you may need to consider saving more, retiring later (or extending your time horizon), or allocating more of your portfolio to a riskier investment that has greater return potential. On the other hand, if less growth is necessary, you may be able to invest in less risky assets that provide less volatility.
What to do next.
Remember, different types of investments offer different levels of risk. As you set up your investments, make sure your advisor understands and aligns your portfolio accordingly. During your regular visits with your advisor, revisit your rate of savings, risk tolerance, investment horizon, and investment goals to make sure you have the right risk and return profile for your portfolio.