Can your stomach tolerate a 30% drop in portfolio value rather quickly? Determining your investment risk profile is one of the first steps any investor should take when thinking about designing a portfolio and an asset allocation. It really will tell you what level of risk you will be comfortable with in your portfolio. It all comes down to what level of risk, or standard deviation, an investor is willing to put up with in the pursuit of investment goals (link to Excel chart creation). In looking at a number of risk profile tools availble on the web, some of which I provided in this post in step X (link), I have seen a theme in terms of the different risk profile definitions. Sure, some of them differ somewhat in either the definition or the number of risk profiles, but they typically go from very conservative to speculative in nature. Here is a pretty good summary of the different risk profiles that I have seen on the web.
You have a need for a predictable flow of income or have a relatively short investment horizon. Your tolerance for volatility is low and your primary goal is capital preservation.
You seek a regular flow of income and stability, while generating some capital growth over time. Your tolerance for volatility is moderate and your primary goal is capital preservation with some income.
Youíre looking for long-term capital growth and a stream of regular income. Youíre seeking relatively stable returns, but will accept some volatility. You understand that you canít achieve capital growth without some element of risk.
You can tolerate relatively high volatility. You realize that over time, equity markets usually outperform other investments. However, youíre not comfortable having all your investments in equities. Youíre looking for long-term capital growth with some income.
You can tolerate volatility and significant fluctuations in the value of your investment because you realize that historically, equities perform better than other types of investments. Youíre looking for long-term capital growth and are less concerned with shorter term volatility.
As you can see, each risk profile covers preservation (i.e. guarantees), risk (i.e. volatility), income, and appreciation. Each one tries to balance each of these to effectively develop a good risk/reward solution when an investor moves to building their portoflio.
One thing that I do take issue with in a number of these risk profile tools is the lumping of income into more conservative strategies. I am after income because of the properties dividend growth stocks exhibit and their ability to provide me with strong capital gains over time through both share price appreciation AND income. I still place myself in the growth / aggressive camps. Income stocks are not just for the retired or the conservative. Income stocks are a great growth tool as well.
(Photo Credit: mono bustos)
I love the way you can always find just the right picture to go with your post. I hope you and your family had joyous Christmas!
I know a 73 year-old guy that invested in stocks and closed-end funds up until this year. Now he has sold all his stocks and put everything in indexed equity funds and indexed ETFs. He read Bogle’s book on Common Sense Investing and declared it one of the best books ever on investing.
I guess the point I am making is that this guy has been very successful in the market and even at 73, he is not going conservative. He is looking to enhance his investments by continuing to learn and invest in new ways.
I am also of the opinion that the general risk tolerance profiles commonly used are “off”. In addition to the point you make, I think that many new investors overestimate their ability to tolerate losses. Things “feel” a lot different when it’s YOUR money going down 30% – all of sudden those charts and stats seem to lose some credibility! 🙂
It might be part of the reason so many newer investors sell at precisely the wrong times…
I think I fit in this somewhere in the growth area. I am not terribly aggressive, but I also don’t want to be too conservative at a young age. I think at a young age being very conservative is actually risking a lot of lost capital appreciation potential.