It isn’t uncommon to ask yourself, “Why doesn’t everyone just hold the same investments, since we all want to make money?”
However, the process of creating and maintaining an investment portfolio is everything but one-size-fits-all. Most individuals and families have different goals and varying resources to help them reach those goals, both long and short term. For example, a younger and working couple will likely not need their retirement savings for a while, so they should implement a different investment strategy than an older couple who is nearing retirement or already retired. And just like the same portfolio won’t work for everyone, your favorite jeans won’t fit your neighbor the way they do you.
Your personalized investment strategy is based on your risk profile, which is made up of two separate factors: risk capacity and risk tolerance.
Your risk capacity is basically an equation calculated using your annual cash flow to determine your savings or withdrawal rate. This calculation tells us where your capacity for risk falls, and in turn, how much of your portfolio should be allocated to stocks, bonds, and cash. The more stocks you hold, the higher your capacity for risk is, and vice versa. Now this is where we bring back in our closet full of jeans.
The trendy and in-style jeans on one side of our closet represent stocks, while the classic-style jeans represent our bonds. In the short term, there is a higher possibility that your trendy jeans will go out of style. However, if you have the time and resources, accumulating more trendy jeans over the long run will increase the likelihood you have something that’s currently in style. With stocks, there is a higher risk of volatility over a shorter time period (think 1-5 years), but if you have a longer amount of time before you need to start withdrawing from your retirement accounts, you have more potential to earn greater returns with less risk, relative to only holding bonds and cash.
The other piece of the puzzle is your risk tolerance, which is how you feel emotionally when you see spikes or drops in the stock market. Understanding the effects of market volatility on your emotions will give insight into how much stock you will be able to tolerate, without feeling stressed out all the time about your savings. Some cannot handle seeing volatility in the short-term, which means they may want to hold onto more of their classic style jeans and play it safe. Every individual is different, some more tolerable of risk than others, which changes the allocation of your stock and bond allocations accordingly.
Although there are two extremes, risky vs. conservative, it is important to use both risk capacity and risk tolerance to correctly diversify your portfolio, as to maximize returns based on your personal timeline and goals. Your risk profile is made up of both of these factors because financially you may be able to hold a lot of stock, but emotionally you may not be able to handle the market volatility.
Don’t know what your risk profile looks like?
Consult an advisor to begin aligning your investments with your short and long term goals. The longer your money is able to be invested, the better chance it can earn higher returns with stocks. On a long-term scale, stocks are projected to outperform bonds and cash, but the question will always begin with what is your risk profile? …and sometimes what kind of jeans are you wearing?
Written by Morgan Martin
