After getting a Christmas bonus, Margaret has trouble deciding what to do with her money. A friend, Abe, sends her an article about investing in small-cap stocks, which are typically more volatile but also have the potential for higher reward.
How can Margaret know if it’s a good idea for her to buy these stocks?
Everyone’s situation is unique, so what might have been a great fit for Abe might not work for Margaret. One of the main factors that she needs to take into consideration is how much risk she can tolerate. And everything – yes, everything – involves risk. Only the dead experience no risk. Intelligent investors must understand how much risk they can tolerate and how much risk they are exposed to, in order to create a strong portfolio. In order to decide what kind of risk tolerance she has, she can start by asking herself these three questions:
Photo by Markus Spiske on Unsplash
1. What is Margaret’s time horizon to retirement?
Over a long period of time, stocks can provide investors a powerful way of increasing their wealth. However, as recent events have shown, stocks have the potential to drop suddenly and precipitously.
What this means is that if a person has a long time until retirement, they’ll have an opportunity to recover from a sudden downturn. But, if Margaret is about to retire, and her investments drop by a lot, she could potentially lose years of retirement income, and without the chance of recovering.
2. How much income does Margaret earn per year?
Consider the possibility that the investments drop in value. How much will this affect Margaret’s quality of life?
If Margaret has a lower income, losing even a small amount from those investments could drastically affect how her finances look during the year.
People with higher income can afford to take more risks because they’re less dependent on those investments to supplement their income.
3. What is Margaret’s current net worth?
Net worth is calculated by taking the value of Margaret’s assets, and subtracting her liabilities (debts). Just like the previous question, those with a higher net worth can withstand a sudden downturn in the economy, so they can withstand more risk.
Conversely, if Margaret’s net worth is lower than her current financial life stage recommends, she might need to take some more risk to catch up.
Photo by Jp Valery on Unsplash
So what’s her risk tolerance?
For the purposes of this exercise, Margaret is planning to retire in the next few years, with average income, and a net worth that is on track for her current life stage. Because of this, a highly risky and volatile portfolio made up of small-cap stocks would typically not suit someone in her position. A more conservative portfolio, made up mostly of bonds, will help her protect her principal investment so she stays ready for retirement.
These questions are designed to get Margaret to design an investment portfolio that will help her wealth grow, and, importantly, will let her sleep soundly. A good financial planner will be able to help her take these factors into consideration and design a portfolio that suits her goals, her preferences, and her financial life stage.
Curious about what financial life stage you’re in? Sign up for a Free Bronze Account and gain access to a Financial Assessment along with a recommended portfolio allocation for your life stage!