If you are professional investment manager, you’ll likely scoff at reading a post about the importance of Risk Assessment. That’s because, for the pros, assessing risk is like breathing – it comes naturally! But many first-time portfolio builders, and far too many DIY investors, might be tempted to jump right into the “Buy Now!” action before consciously weighing the risks of their decisions.
Better Risk Assessment = Better Portfolios
Before you start putting a portfolio together, by buying the “hottest” stocks you hear about on the news or at a friend’s bachelor party, you need to do what’s called a Risk Assessment. While financial advisors (and more recently, Robo Advisors) have been using this tool for decades, to understand how to create better portfolios for their clients, individuals and DIY retail investors often neglect this aspect of portfolio construction.
Here are three aspects of Risk Assessment that you need to understand before you start constructing your portfolio:
1) Risk Tolerance: First, measure the amount of risk that you are willing to take when putting together your portfolio. Are you willing to risk losing 50% of your portfolio to make a 150% gain?
2) Risk Capacity: Then, determine how much risk you can truly afford to take with the portfolio, given your current financial situation, in the pursuit of your investment goals. For instance, will losing $10,000 put a significant dent in your savings/retirement plans?
3) Risk Attitude: These two factors determine how much risk you choose to take when constructing the portfolio. Your attitude to risk is like a “gut feeling” that will either urge you to embrace, or steer you away from, certain types of investments.
Without conducting this type of a formal risk assessment, it is highly unadvisable for anyone to start creating a portfolio – no matter how savvy you might be in your knowledge of PE-Ratios or Price-to-Book Values.
The more time you spend understanding your tolerance (or aversion!) to risk, the better informed you will be when putting the building blocks together for your portfolio. And these building blocks may include Stocks, Bonds, ETFs, Mutual Funds, Certificates of Deposits (CDs), or even alternate investments like Commodities and Precious Metals.
Portfolio Risk-Reward Decisions
When building your portfolio, you must consider your risk reward profile. Your aversion (or lack thereof!) to risk will steer you to less risky portfolio mixes which, by definition, deliver lower returns.
According to investment management firm Vanguard, the historical returns for an investment portfolio have ranged from 5.4%, for a risk averse portfolio of all Bonds, to 10.2%, for an extremely risky portfolio of all Stocks, with a more moderately risky portfolio, of 50% Stocks and 50% Bonds, yielding 8.3%.
If your portfolio choices don’t fall within the spectrum of these three, there are a whole array of other portfolio models that you could construct, comprising more Bonds and less Stocks (e.g.: 80% Bonds/20% Stocks), to less Bonds and more Stocks (e.g.: 80% Stocks/20% Bonds). The mix of assets you choose to add to your portfolio will depend entirely upon your risk tolerance, and your capacity to absorb risk.