A survey of U.S. households found that about two-thirds were willing to assume some investment risk in order to earn a return. For example, 35% said they were comfortable assuming an average risk burden for an average gain. Another 22% said they would be willing to take above-average or substantial risk as long as the return potential was also above average or substantial.1
These are unsurprising answers. Many people base their ideas about risk tolerance on subjective standards — their feelings — without considering whether their personal circumstances would either exaggerate or mitigate the risk inherent in a particular investment. Feelings are important, but they should play only a supporting role when deciding how much risk is appropriate for your situation.
Nonetheless, if your portfolio is overexposed to risk, your feelings may be your first indication. For example, what was your reaction to the “flash crash” in May 2010? On that day, a trading anomaly caused the Dow Jones Industrial Average to plunge nearly 1,000 points.2 If this event struck terror in your heart, it’s a good indication that you may be carrying too much risk.
Here are some other indications that you could be overexposed to risk.
A large percentage of your net worth could disappear overnight. This is where it’s easy to see that risk tolerance is a personal consideration that extends far beyond the risks that are specific to a particular investment. Consider two hypothetical investors: One has a $5 million net worth; the other’s most significant asset is $100,000 in his 401(k) plan. Each makes a $50,000 investment in the same security. Even though the investment itself poses identical risks to these two individuals, the millionaire is assuming far less risk because even a total loss would amount to only 1% of his net worth. The other investor is taking on needless extra risk by exposing half of his retirement assets to the fate of a single security.
You would need to sell some of your investments to cover a personal financial emergency. If you were faced with a large, unexpected expense and would need to liquidate some of your investments to cover it, it’s probably an indication that you are in over your head.
There are many considerations when evaluating how much risk is appropriate for your portfolio. We can help you evaluate your risk tolerance as it changes over time. Please contact us at 630-548-9600 for additional Naperville Wealth Management options.
1) Investment Company Institute, 2009
2) The Wall Street Journal, May 19, 2010
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2010 Emerald.
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