There are some things investors enjoy thinking about more than others. We all like to imagine our portfolios soaring in value, but we're rather more squeamish when it comes to market crashes and corrections. Returns and risk go hand in hand; returns are the reward investors receive for the risk they take. But it's human nature to want one without the other — in other words, to have our cake and eat it.

As Mark Hebner writes in Step 8 of his award-winning book. Index Funds: The 12-Step Recovery Program for Active Investors, the substantial market declines we saw in 2008/2009 and in March of 2020 made people more aware of the possibility of heavy losses, but we prefer not to think about it.

"People are still looking for that perfect investment with small risk and big returns," Hebner writes. "They're also still looking for a weight loss pill that will allow them to continue eating country-fried steak, massive cinnamon buns, and ice cream on a regular basis. Neither exists."

 

You Need To Be Realistic

To be a successful investor, you have to be realistic. You need to acknowledge that although there are some types of risk you can mitigate — being too heavily concentrated in a particular type of asset, for example — there is nothing you can do to avoid a general market downturn.

In other words, if you want to receive what's called the equity premium, or the excess return that investing in stocks provides over a "risk-free" asset like cash or government bonds, you have to accept a degree of risk.

The key question you need to find an answer to is, how much risk should you take?

It might seem like a simple question. But it's far more difficult to answer than most people imagine. It depends on a number of different things — not least your own personality and psychological make-up. So where do you start?

What We Mean By Risk

The first step is to understand what we actually mean by risk. We're not talking here about a permanent loss of capital. If you buy, say, just one stock, or one type of cryptocurrency, there is a very real risk of losing all of your money. But, if you invest in a broadly diversified portfolio of index funds, it's extremely unlikely that all of your money will be wiped out.

As Mark Hebner explains in Step 9 of his book, capitalism has proved remarkably resilient over time. There've been numerous events over the last century or so which have sent the markets into a tailspin, and yet, on each occasion, stock prices have always recovered and eventually reached new heights.

So when we talk about risk, what we're actually referring to is market volatility. More specifically, we're referring to the possibility that market volatility will mean you can't access the money you need at the time you need it, or that it will cause you to take fright and abandon your chosen strategy.

With that definition out of the way, it's time for some serious thinking on your part. I would argue that there are three main issues you need to think about when working out how much risk to take: your need to take risk, your tolerance for risk, and our capacity for risk. Let's look at each of those three in turn.

1. Your Need For Risk

All sorts of everyday activities involve risk. But we make a calculation that the risk is worth taking. Everyone knows, for instance, that driving a car has its dangers, but most of us choose to do it anyway because of the convenience, freedom and efficiency it offers.

It's no different with investing. Most people, unless they're lucky enough to have inherited substantial wealth, have no choice but to invest if they want to maintain their standard of living into retirement.

But some people need to take more risk than others — those, for example, who started to invest later than they should have, or those who haven't put enough money away on a regular basis. The higher the expected return you need to meet your goals, the higher the amount of risk you need to take.

By the same token, some people may need to take little risk, or none at all. They may, for instance, already have a very large retirement pot. It may even be large enough as it is to last them for the rest of their lives. If you're satisfied with your lifestyle, the possibility of increasing your lifestyle by another 50% is surely not worth the risk of being forced to reduce it by 50%. In other words, if you've already won the game, stop playing!

2. Your Tolerance For Risk

Tolerance for risk refers to an individual's ability, emotionally and psychologically, to take on, accept, and deal with the uncertainty and volatility associated with investing in stocks.

Risk tolerance is subjective and varies from person to person. It's influenced by your personality, your past experiences and your need for stability. It's also affected by the behavioral biases that each of us is prone to.

Some people have a high tolerance for risk. They feel relatively relaxed about the prospect of the value of their portfolio falling by, say, 30 percent. When markets suddenly fall, they take little notice, reminding themselves that it's the returns they receive over the very long term that really matter.

Other people are far more sensitive to market volatility. They tend to fret when stock prices fall. Worse still, they can be tempted to reduce their exposure, or even bail out altogether, because it's just too hard to endure the discomfort they feel.

3. Your Capacity For Risk

For many financial advice firms, tolerance for risk is the all-important thing. But for us at Index Fund Advisors, it's only part of a much broader issue, namely capacity for risk.

Simply put, your capacity for risk is the ability you personally have to experience losses to your portfolio without suffering a major life setback or a significant reduction in your standard of living.

We give each of our clients a risk capacity score, ranging from one to 100. The score is based on five specific dimensions of risk capacity — your time horizon, your attitude towards risk, the investments you already have, the income you earn, and the level of your investment knowledge.

The aim is to take as much risk as you need to, can afford to, and as you feel comfortable with — but no more. Taking too much risk — or indeed too little — can land you in serious difficulties.

When, and only when, we have correctly identified your risk capacity score, we can move to the next step, which is to match your risk capacity to the right asset allocation, or risk exposure.

Time For Action

We can't impress on you strongly enough how important it is to consider the issues discussed in this article. Arguably the biggest reason why people fail to achieve their investment goals is that they take an inappropriate amount of risk.

It's often only when people experience a sharp market decline or a prolonged bear market that they realize they had over-estimated their risk capacity. It's also very common for people to recognize, too late, that they failed to take enough risk, and that they should have invested more in equities instead of having so much money sitting in cash or bonds. In both cases, the consequences can be disastrous.

If you haven't yet worked with a financial planner to identify your capacity for risk, the time to do it is now, and the older you are the more urgent it is.

Perhaps you thought about your capacity for risk many years ago and haven't considered it since. If that's the case, you should certainly do it again. Our need to take risk and our capacity for risk are almost bound to alter as we get older and our circumstances change.

The good news is, whether you're working out your risk capacity for the first time or the second, is that doing so will greatly improve your chances of achieving your investment goals.

As Mark Hebner writes: "When investors actively participate in the investment process by conducting the self-examination required to establish a risk capacity score, they better position themselves to weather appropriate levels of market volatility, thereby enhancing their ability to experience a high degree of investment success."

So don't delay. Just click on this link and answer a few basic questions. We look forward to hearing from you.

 

HOW CAN WE HELP YOU?

Do you have any questions about this subject, or any other issue related to investing? If you do, we would love to address them in future content.

Simply email your question to [email protected] with your name and where you live and we'll do our best to answer it.

 

*Quotes and pictures are utilized for illustrative purposes only and should not be construed as an endorsement, recommendation, or guarantee of any particular financial product, service, or advisor.

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ROBIN POWELL is IFA's Creative Director. He always works as a freelance journalist and author, and as Editor of The Evidence-Based Investor.

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal.  Quotes and pictures are utilized for illustrative purposes only and should not be construed as an endorsement, recommendation, or guarangee of any particular financial product, service, or advisor. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.