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Welcome to Select’s newest advice column, Getting Your Money Right. Once a month, financial advisor Kristin O’Keeffe Merrick will be answering your pressing money questions. (You can read her first installment here on what to do with your excess cash.) Have a question you want to ask? Send us a note at AskSelect@nbcuni.com.
I recently had a conversation with someone about investing and was asked about my risk tolerance. I was a bit stumped by this question. I don’t really know what my risk tolerance is, what the question means or how I go about figuring this out. Is it an important part of investing? I would love some guidance as I begin investing.
Risk-Confused in Raleigh
The term “risk/reward” gets thrown around often but many times people don’t actually understand what it means. Understanding risk, what it means and why it matters is a cornerstone to smart investing. Before we can go any further on our investing journey, it’s important to break down this topic.
What is risk?
I always tell my clients that risk is something that can be measured by both quantitative and qualitative measures. We will get into the “quant-fun” in a bit, but first let’s talk about feelings.
Taking a big risk (financial, professional, personal) can be scary and thrilling at the same time. For example, skydiving is certainly a risk. You can measure it with statistics (example: a certain percentage of skydivers fall and die when they jump out of a plane) or you can measure it with other metrics. “I will be so terrified of the jump that I might die from fear.” These qualitative measures are a bit more difficult to gauge, but they are still very real.
When you’re getting started investing, it’s important to know where you fall on the general risk spectrum. There are a lot of questions to answer when trying to ascertain your risk tolerance. Here are a few:
- Do I make quick decisions?
- Do I trust my instincts/gut?
- Looking back, how has my decision-making process served me or hurt me?
- How does my stomach feel when I am taking risks? Do I feel sick? Am I excited?
- Am I someone who can understand reason, facts and historical context or am I someone who will panic and head for the exit at the first sign of duress?
During the early days of lockdown, in mid-March 2020, the markets were crashing. It was ugly, and it was tough. However, I was able to use context to deal with the crisis at hand. I worked on a currency desk through the 2008 financial crisis, and so I was armed with facts, history and an in-depth knowledge of how risk works.
That said, several clients were in a full-blown panic. They were watching their investments fall in value, they were losing money and, well, there was (is) a global pandemic. It was scary! Each time I spoke with a client, I immediately had to vibe where they were on what I call the “risk spectrum.” Were they ready to sell everything and move into a bunker? Were they ready to “buy the dip?” Understanding where you sit on this spectrum will be very helpful for you as an investor and as a human.
Knowing where you fall on this spectrum is important, but it should not be the deciding factor in making investment decisions. For example, as a young trader on Wall Street, I used to trade small amounts to get a better understanding of how markets work — I figured that if I risked small amounts I couldn’t hurt anyone! I learned very quickly that taking short-term risk was not for me. I could not stand losing money. I would get sweaty, not be able to eat my lunch and eventually exit the position because I couldn’t take the heat.
With age and experience however, I now understand that taking risks is about more than how it makes you feel. You need to understand the time horizon you are dealing with, you need to be able to understand that over time markets trend higher and, in the end, if I am making educated decisions about my investments and monitoring them appropriately, I know I have done the best I can.
It is important to highlight that in the past few years, the stock market has been on an unprecedented march higher. As a result, many people have entered the market and have made exceptional amounts of money. They now also believe that they are experts. I would remind you that no one thinks much about risk when the market is going up, but when the market starts to come down, you will be happy that you have taken appropriate risk measures.
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Risk/Reward: It’s not just a catchy phrase
Perhaps you have had conversations with people who say things like “I am risk averse” or “I eat risk for breakfast!” To eat risk for breakfast, I have always found it helpful to envision the four quadrants of risk. If “risk” is measured from low to high on the X-axis, and “reward” is measured from low to high on the Y-axis, you can imagine that the bottom left quadrant will be the “low risk/low reward” quadrant. If you do nothing with your money, you are not risking it, but you will also not make any return on that money (think keeping it in a checking account). Therefore, you take no risk and receive no reward.
In the quadrant above (upper left quadrant), you will be higher on the risk scale but low on the reward scale. For example, if you’d jump off a cliff if someone offered you a pretzel in return, this is your quadrant. In case you need clarification, this is not where you ever want to be. Losers live in this quadrant.
The quadrant to the right of this is the high risk/high reward quadrant. If you are an entrepreneur, a day trader or a venture capitalist, this is your quadrant. This quadrant means that you are taking exceptional risk, but your opportunity for reward is very high.
Finally, the lower right quadrant is the low risk/high reward quadrant. Clearly this is where we would all like to live. If you inherit your wealth or are an oligarch, you can live in this quadrant! For most of us, however, this quadrant is something we can only dream about.
How does risk/reward translate into investing?
Almost all securities (bonds, stocks, currencies, commodities) have a measure of risk. Without getting too deep in the weeds, this measure of risk is called standard deviation. You may remember this term from statistics or math. Standard deviation is a measure of how spread out a certain batch of numbers is with respect to the average (mean). If the data point is further from the mean (average), there is a higher standard deviation. Therefore, if you buy a stock with a high standard deviation, it means that its price changes with more severity than other securities like it. The change in price is called volatility, and the higher the volatility, the higher the risk. Have I scared you yet? Don’t overthink this.
Think of standard deviation as a grade for risk. For example, if you own a U.S. treasury bond, your bond has a lower standard deviation than if you owned a tech stock because the bond’s price changes with less severity. All securities fall into the risk spectrum and are generally grouped by a category called asset classes. Asset classes are just categories of securities that have similar characteristics (large, small, foreign, domestic, etc.).
Painting broad strokes, bonds generally have a lower risk measure than stocks. Currencies (euros, yen, etc.) and commodities (example: gold, silver, wheat, steel) generally have higher risk measures than stocks. Each asset class has its own measure of risk, and these asset classes are blended when building portfolios to spread out risks. Therefore, when choosing what you want to invest in, it is important to know how much risk you are taking. You can do this by looking at the standard deviation of the single security (stock), mutual fund, ETF, currency or bond. This information is readily available on sites like Morningstar or Yahoo Finance.
Diversify your portfolio!
If you decided that you wanted to take your life’s savings and buy one small biotech stock that has only one patent pending, you would be assuming quite a bit of risk. Without knowing much about the stock, we could ascertain that you are parking all your money in the high risk/high reward quadrant.
If, instead, you decided to put 25% of your money into this biotech stock and the rest of your money in blue chip stocks with a much lower standard deviation, you would diversify your portfolio while significantly reducing your risk. This allows you to still take calculated risk and buy the biotech stock, but in the event the biotech stock goes to zero, you have the rest of your portfolio to keep you afloat.
However, too much diversification is not always the right path. If you diversify too much, you spread your portfolio so thin that it becomes too difficult to make any money. For example, if you have $10,000 to spend on some stocks and you buy 100 different stocks, you could find it frustrating when you have only made small amounts of profits on each position. Many mutual funds have over 500 holdings. If you buy 10 mutual funds with your cash, think how diversified your portfolio has become!
Taking appropriate risk
What does this all mean? It means that it is important to invest in things that you believe are great growth opportunities, align with your values and are not taking unnecessary risk. This does not mean that you cannot take risks. Part of understanding how to invest is differentiating between good and bad risk. Remember that jumping off a cliff for a pretzel is dumb, but investing in a biotech company that is making big changes in the world could be very lucrative!
Also, time horizon matters. If you are 30 and you are making contributions to your 401(k), you have at least a 30-year runway to grow this money. You can afford to take more risks. Conversely, if you are planning on a home purchase in the next year, you should be much more careful about your risk tolerance as you do not want to risk losing some of your down payment.
When building your portfolio, do your research. Consider hiring a financial advisor if you need more help. Also, most robo-advisors will have you fill out a risk questionnaire before you begin investing. These can be helpful tools to guide you through your journey.
My final thought is this — have someone look at your portfolio to tell if you are taking the right amount of risk. Time horizon matters and many people do not take enough risk over their lifetime. This can materially impact the amount of money you have in the long run. Good luck!
Kristin O’Keeffe Merrick is a Financial Advisor and money expert at her family-run firm, O’Keeffe Financial Partners, located in Fairfield, NJ.
Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.