Among my top ten financial planning resolutions, number 7 is to determine how much risk you can handle.
Risk and return are linked: the higher the potential return, the greater the risk. Treasury Bills and Notes have almost no risk to principal; corporate bonds and junk bonds have more; stocks still more. It all has to do with where the investment lies on the cash-flow food chain. The government (almost) always gets paid; then debts get paid; finally owners get what’s left over. But the owners benefit most from any growth.
Higher risk doesn’t always mean higher returns. But higher potential returns require higher risk. That’s a verity of finance. If you want the upside, you have to deal with the possible downside. And as we know, the downside sometimes happens.
That’s why investment pros start with risk—how much you can handle—before they get to return. And there’s a pretty simple test to figure out your risk tolerance. Imagine your nest-egg cut in half. That’s how much the stock market has fallen the last two cycles. If you think you could hold on through that and not panic at the bottom, you can probably tolerate a diversified equity portfolio.
If not, imagine your portfolio down by 15%. That’s what a serious bond market decline entails. If that’s too much, short-term bonds are usually limited to about a 5% decline. If that’s too much, stick to FDIC-insured bank CDs. But you’ll have to settle for 1-2% returns, because safety doesn’t pay well.
A mixture of stocks, bonds and cash will fluctuate over time. How much fluctuation you can handle will determine what proportions to use. That’s a critical factor in knowing yourself, and a critical element in managing your portfolio.
Douglas R. Tengdin, CFA
Chief Investment Officer
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