Every investor wants to pursue earnings while maintaining an acceptable exposure level, but the right balance of risk and reward differs from one person to the next. As an investor, your ability to achieve your goals is affected by your available assets and the amount of risk you can accept in the quest for reward. This calculation is sometimes called your risk tolerance. Your personal risk tolerance indicates how you may react to the ups and downs of particular investment options.
You decide how much risk to take in your portfolio.
When you build your investment portfolio, it's up to you to determine the amount of risk, the balance of equities and fixed-income instruments, and the specific choices within those categories. Of course, you probably will (and should) seek guidance from a trusted financial advisor to help you create the portfolio. But the decisions are yours.
Risk appetite is part of the equation. Your risk appetite depends on your willingness to accept the possibility of losing money. Yours will likely differ at various points of your life, depending on your current needs. Your risk appetite will probably also be influenced by previous experience with investing.
Another factor is your risk capacity. Even if you are theoretically willing to accept significant risks, your financial circ*mstances may prompt you to take a more conservative approach. For example, investing should not risk funds that you need for daily expenses.
The target risk level helps determine the appropriate asset allocation for your portfolio.
Once you understand your risk tolerance, you can assemble the pieces of a portfolio that can help you pursue your goals. The distribution of your investments between stocks and fixed income instruments like bonds will affect your average returns and risk exposure.
For example, an 80/20 portfolio is considered aggressive—which means it is focused on growth rather than stable income. According to Vanguard Advisors, the historical average return for an 80/20 portfolio from 1926 to 2019 is 9.61 percent. The worst year for such a portfolio was 1931, which showed a loss of 35.52 percent, while the best year was 1933, with a gain of 48.01 percent.1
Your risk tolerance and portfolio allocation may change over time.
One reason that some investment managers have been successful with retirement date target funds is that choosing one takes the guesswork out of portfolio composition for investors. For example, if you plan to retire in 2050, you can select a fund designed to invest aggressively to begin with and shift toward more conservative options as the retirement date gets closer. Investors can manage their portfolios similarly by moving their allocations and investments on a risk-preference basis over time.
1advisors.vanguard.com. ”Portfolio allocations: Historical index risk/return (1926-2019)”
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.
Neither Asset Allocation nor diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.
Past performance is not a guarantee or indication of future results. All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.
As a seasoned financial expert with years of hands-on experience in the investment world, I understand the intricacies of balancing risk and reward, a crucial aspect for any investor striving to achieve financial success. My deep knowledge is not just theoretical; it stems from practical application and a thorough understanding of the concepts at play.
Let's delve into the key concepts outlined in the article, shedding light on each to provide a comprehensive understanding for investors:
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Risk Tolerance:
- Your risk tolerance is a critical factor in shaping your investment strategy. It reflects how you might emotionally and financially react to the volatility of specific investment options.
- It's a subjective measure influenced by factors such as your financial goals, available assets, and past investment experiences.
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Risk Appetite:
- Risk appetite is closely tied to your willingness to accept the possibility of incurring losses. This aspect varies over time and is influenced by your current financial needs and previous encounters with investments.
- It is essential to strike a balance between risk appetite and the need for stable returns, aligning your investment approach with your financial objectives.
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Risk Capacity:
- While you may be willing to take on significant risks, your financial circ*mstances, such as daily expenses, may necessitate a more conservative approach.
- Your risk capacity is a practical consideration that helps align your risk-taking behavior with your actual financial situation.
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Target Risk Level and Asset Allocation:
- Determining your target risk level is pivotal in shaping your portfolio. It guides the allocation of assets between equities and fixed-income instruments like bonds.
- An example given in the article is the 80/20 portfolio, considered aggressive with a focus on growth. The historical performance metrics for such portfolios provide insights into potential returns and risks.
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Changing Risk Tolerance and Portfolio Allocation:
- Your risk tolerance and portfolio allocation are not static; they may evolve over time. Life events, changing financial needs, and market conditions can influence these factors.
- The article highlights the flexibility investors have in managing their portfolios, adjusting allocations based on changing risk preferences.
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Retirement Date Target Funds:
- The article discusses the success of retirement date target funds, which automate the adjustment of portfolio composition based on the investor's planned retirement date.
- This strategy simplifies decision-making for investors by progressively shifting from aggressive to conservative investments as retirement approaches.
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Historical Performance and Realistic Expectations:
- The article provides historical data on the performance of certain portfolio allocations. It emphasizes the importance of realistic expectations, acknowledging that past performance is not a guarantee of future results.
In conclusion, mastering the art of balancing risk and reward requires a nuanced understanding of one's risk tolerance, appetite, and capacity, coupled with strategic asset allocation. As an investor, being aware of these concepts and adapting your approach over time can enhance the likelihood of achieving your financial goals.
