The Build My Own Portfolio feature within your plan includes a tool that measures the risk level associated with the portfolio you have chosen. This risk level is essentially the weighted average of the risk levels associated with each of the underlying funds, as determined by the manager of that fund. The purpose of this article is to help you understand investment risk and to determine the risk level that is most appropriate for you.
What is investment risk?
Risk refers to the uncertainty that comes with investing, measuring how much money you could potentially lose on your original investment. It also has to do with the chance that you will not achieve the financial goal associated with a particular investment.
We can’t talk about risk without also talking about investment return — what you can gain from the investment you make, over the amount you initially put in. Generally, risk and return are two sides of the same coin. Funds that offer higher potential returns also come with a higher level of risk. It’s essential to find a balance between risk and return that aligns with your financial goals and personal comfort level. If you are many years away from retirement, you can focus on returns over risk since you have time on your side. Whereas if you’re approaching retirement, you will likely need a more balanced risk-return approach.
The different elements of risk
There’s more than one element of risk to consider. For example:
- Risk tolerance is your comfort with risk. It has more to do with your mindset or psychology than your financial situation. For example, someone with a low risk tolerance would be more likely to take their money out of the market when the market goes down, even if they don’t need the money for a long time. Someone with a higher risk tolerance would be more likely to leave their money invested through market downturns. They would not worry too much about these shorter-term market ups and downs since they do not need the money for a long time.
- Risk capacity is your financial ability to take a risk. It has more to do with your financial situation and goals than with your mindset or psychology. For example, you have a low-risk capacity if investment losses in the short term will have a negative impact on you financially because you need the money to meet short-term goals.
Your risk tolerance and risk capacity can be the same or different. For example, you might have a high-risk tolerance and want to choose riskier funds in hopes of higher returns. But, if your time horizon to invest is short (e.g., you’re saving for a down payment on a home) or you have debt or instability with your income, you are better to take less risk with your savings to ensure your money is there when you need it.
What is your risk level?
By looking at both risk tolerance and risk capacity, you can figure out your own risk level. The tables below provide a guide to where you fit on each of these elements of risk.
Risk Tolerance: Choose which best describes your comfort with risk
Protecting your money is most important to you.
You want to avoid changes in the value of your investments when the market moves up and down. Even smaller changes make you nervous.
You want some growth, but protecting your money is more important.
You are comfortable with smaller shifts in the value of your investments.
You want a balance between your money growing and still being protected.
You want the opportunity for your money to grow over time. You can accept some shifts in the value of your account to achieve this.
Growing your money is more important than protecting it.
You are somewhat comfortable riding out the ups and downs of the market.
Growing your money is most important to you.
You are comfortable taking risk in the pursuit of higher potential returns. Longer-term growth is your focus, and the market ups and downs don’t worry you.
Risk Capacity: Choose which best describes your financial ability to take on risk
|Investment losses would have a big impact on you.
It may be difficult for you to recover from losses in time to reach your goals, especially if you will need the money in the next few years.
|Investment losses would have an impact, but you want the potential for some growth.
You may have a shorter time horizon or other financial obligations. You can take some risk in exchange for potential growth.
|Investment losses would have an impact, but you feel financially stable.
You are comfortable with how much you’ve saved and are willing to balance risk and return.
|Investment losses would have some impact but would not significantly impact you reaching your financial goals.
You can take more risk with at least some of your portfolio. You have the time to recover from any losses.
|Investment losses would not likely impact reaching your financial goals.
You are most concerned with seeing fast growth in your investments. You won’t need this money in the next 10+ years.
Your risk level is….
Generally, the answer in the column farthest to the left across both tables highlights the risk level that might be right for you. For example, if you chose “Medium-high” for your risk tolerance but “Medium-low” for your risk capacity, you may want to take more risk, but are not currently in a financial situation to do so. Choosing a mix of funds with the “Medium-low” risk level may be a better choice for you today.
Compare your risk level to the calculated risk level of your target allocation to ensure you are comfortable with your fund selections.
Your risk level may change over time
Unlike a target date fund, your investments won’t automatically rebalance to reduce risk as you get closer to your retirement date. It’s a good idea to regularly check your risk level, especially with any life changes (e.g., marriage, job loss). If this isn’t something you want to do, you may be better suited to a target date fund that is personalized for your target retirement age.
A financial advisor licensed to give investment advice can also help you gain a deeper understanding of your risk level and help you with investment strategies for your current financial situation. If you find your need for risk to meet your financial goals is higher than your risk tolerance and risk capacity, a financial advisor can help you review your savings rates and goals. If you have a spouse or common-law partner, you should consider your overall family risk need and how your savings in this plan fit into your larger financial goals.
Want to learn more about risk and investing?
Here are some resources to check out: