Why Every Investor Needs a Risk Management Strategy
Becoming an investor goes beyond just putting some money into a portfolio. It involves knowing how to prevent that investment from declining during periods of economic distress, and understanding how to maximize returns while minimizing risk.
Whether you choose to manage your portfolio yourself or hire a financial advisor is a personal choice. However, most successful individual investors choose to hire an investment professional who can provide ongoing guidance for managing investment risk.
The first step to take when developing a risk management strategy is to determine what your actual risk tolerance level is. Risk tolerance refers to the maximum level of risk you are willing to take within a given portfolio. A person’s risk tolerance is often based upon a number of factors, including investment time frame, investable asset and investment goals. And, a person’s risk tolerance will change over time.
For example, an investor’s risk tolerance during their 20’s will likely be substantially higher than an investor in their 50’s when it comes to retirement planning, as the 20 year old has a longer period of time for their portfolio to recover in the event of a market correction.
Here are some basic definitions and categories of investment risk tolerance for your consideration:
- Aggressive- An aggressive investor is someone looking to outperform the market in terms of annual returns. They typically have a longer investment time frame, 10+ plus, and are comfortable with large variances in their portfolio value on an annual basis.
- Moderately Aggressive- A moderately aggressive investor is someone looking to perform at a similar level to the market’s average, often compared to the S&P 500 index average return. This investor often has investment time frames ranging from 5-8 years and is comfortable with some variances within their portfolio’s value, but less so than an aggressive investor.
- Moderately Conservative- A moderately conservative investor is often approaching their investment goal, and as such, as more conservative in their approach to choosing investments. Many of these investors are within 3-5 years of their goal, and are uncomfortable experiencing variances within their portfolio’s value. And, a greater portion of their investment allocation will be placed into income producing assets as opposed to equity assets.
- Conservative- These investors are often within 1 year of their investment goal, or are already in their retirement years. A conservative investor is often more interested in current income than capital appreciation, selecting a portfolio with a higher percentage of bonds and income producing investment vehicles.
Once you determine what your personal risk tolerance level is, you can develop an asset allocation which is in alignment. An asset allocation allows you to maximize portfolio return while managing or minimizing risk. Once you allocate your capital, you will make necessary adjustments on an ongoing basis to ensure your capital remains in alignment over time.