If we were going to enter an autocross race, it would be important to understand the capabilities and limits of our vehicle before the green light flashes. It’s the same deal with investing and, in this case, you are the car. Before we start investing in, we need to understand how much risk you can handle, both from a financial and an emotional standpoint.
What is risk? When it comes to investing, risk is the idea that you may – temporarily or permanently- lose some (or all) of the money you’ve put in.
Risk can often be confused with volatility, which is the “normal” level of fluctuation for any given investment. In layman’s terms – risk is the idea that your boat might crash, volatility is how big the waves are. For example, the stock market and commodities have high volatility; prices can move quickly and substantially up or down, seemingly at the drop of a hat.
Just like an engine has a normal range of operating temperatures, it’s important you understand your “normal operating limits” for risk in investing, and to understand what happens when you get out of this zone. Typically, if we’re beyond our comfort level, we become more likely to make emotional decisions instead of logical decisions.
Emotional decision making can snowball on you; it can increase your overall risk and dramatically impact your investments. This emotional “zone” can also result in lack of sleep, high stress, frustration, and anxiety, which can in turn lead to more emotional decisions. A vicious cycle. Hopefully, you’re starting to see why it’s better to set your limits beforehand, when you’re thinking clearly and logically.
What are stocks and bonds?
Bond (fixed income) investments are a form of a loan. They will have a stated interest rate and a time period until maturity attached to them. Also, they are usually more conservative, lower-risk opportunities. In a 401(k), a bond investment is usually either a US Treasury, Foreign or Corporate bond. In most normal market environments, bonds typically move opposite of stocks, helping to provide balance & diversification to a stock portfolio. As a trade-off, bonds do not typically increase in value like stocks.
Stocks, or “equities”, are actual shares of ownership in a company. In your 401(k), stocks are available in the form of “Mutual Funds” or “ETFs”. These types of investments are baskets of many different stocks which are either chosen by a professional fund manager or to mimic an index (such as the S&P 500). Equities are typically more aggressive investments than bonds, moving directly up or down in step with the overall market. The equity investor is hoping that the value of his investment goes up over time.
How risky am I?
To help you get a handle on your individual risk tolerance, INVST offers this risk tolerance questionnaire to determine your risk profile.
The science and data behind the quiz were compiled by researchers at Kansas State University and North Dakota State University. The quiz presents different financial scenarios, asking the investor to analyze how they would respond in each situation. The results help you — and us — understand how much risk you’re able to handle and your instinctual response to different hypothetical scenarios.
The quiz takes about 10 minutes to complete and is an essential first step in the investment management process.
Words like “conservative” and “aggressive” show up in my risk profile; what do they really mean?
To be a conservative investor means that the investor prefers consistent returns on investments and tends to shy away from investments that fluctuate in value. A conservative investor will typically focus on picking cash-based investments or low-risk fixed income (bond) type investments. This type of investor usually has a smaller (or none) selection of stock-market based investments.
To be a moderate investor means that some fluctuations in investments are acceptable in order to produce a slightly higher return. In real life, a moderate investor is selecting a diversified blend of stocks, bonds, cash. The volatility of the stock-market based investments is balanced out by the lower volatility of the cash & bond-type investments.
Finally, an aggressive investor is willing to accept substantial fluctuations (volatility) for the highest possible returns on their investments. An aggressive portfolio typically contains mostly stock investments, with minimal positions in bonds and cash. The higher returns should be generated from the stocks, but there’s also a higher commensurate level of risk.
Ok, I’ve completed the quiz, now what?
Now that you’ve “scored” yourself, the next step is to match up your investment style with your risk profile.
If your quiz indicated you have a high level of comfort taking risks, it would be suitable for you to choose higher-risk, higher volatility investment opportunities. In your 401(k), if you’re using a target-date fund or a pre-built portfolio (see below), you can generally pick a target fund which lines up with your age 65/70 or a pre-built portfolio titled with the words “Equity” or “Aggressive”. If you’re building your own custom portfolio, it would be appropriate to lean towards equity investments with smaller portions of bond & cash investments.
If you’re less comfortable with taking risks, you’ll want to take a safer approach that has less volatility. In this scenario, this typically means less stock-market investments and more bond or cash-based investments. In your 401(k), you may want to consider shying away from target funds as the default risk level in those funds might be out of bounds for you. Instead, you may want to consider using a pre-built portfolio titled “Moderate”, “Conservative” or “Fixed”. If you’re building your own custom portfolio, it would be appropriate to lean towards bond and cash investments with smaller portions of equity investments.
Ok, I get it, but please help me
As part of your 401(k) program, Invst has created several “pre-built” portfolios which will line up with the risk tolerance questionnaire you completed. We have mixed stocks and bonds to provide a suitable portfolio for the conservative, moderate and aggressive investor.
We hope you find this more useful than 401(k) investment experiences you’ve had before.
In addition to these pre-built portfolios, you’ll also have the option to choose “target date funds”, which are professionally managed baskets of stocks and bonds. Target funds automatically reduce risk as time goes on, decreasing the stock holdings and increasing the bond holdings as you near retirement.
Of course, for you DIY people, you’re still able to create your own custom portfolio by selecting your investments directly off the menu. We have a point of caution, however: sometimes when an investor believes they are building a diversified portfolio, there is overlap between the investments they’ve chosen, and they may not end up as diversified as they think they are.
The advantage of using a pre-built portfolio or target fund is that the manager has taken care of this (and many other issues) ahead of time. You may be tempted to invest based on things you hear on the news or from your co-workers; heck, they seem like (and probably are) pretty smart people. However, when it comes to investing, for most of us, it’s better to leave portfolio construction to the pros.