Here’s How You Can Check Your Portfolio’s Risk Level
A general portfolio is a mix of equity, bonds, and cash, each with its own risk and reward trajectory. Equity or stocks are riskier and highly rewarding, while on the contrary, bonds are subject to a lesser threat but can also have lower returns. In a typical scenario, people like to believe that the higher the risk, the more returns you can likely earn and vice-versa. But the right balance of risk and reward varies from person to person, depending on several factors such as risk capacity, age, overall objective, etc. As a general rule, the risk-taking ability of a person reduces with age. In addition to this, the changing market forces also tend to impact the portfolio’s overall returns. Hence, it is critical for you to consistently monitor your investments and assess your portfolio’s risk level to ensure that your overall objective is not compromised.
To determine the risk of your portfolio, it is vital to analyze these two important factors which will depict your risk appetite and preference:
The most crucial factor that affects your risk ability and preference is the time horizon for which you plan to invest your money. For investors who aim to invest money for a short duration of time, choosing highly volatile investments such as stocks may not be a great idea. Instead, investments in bonds and other safer securities could be the ideal way. For instance, if you want to invest your money for two years and wish to buy a house from the money you earn, it would be wiser to take less risk and choose more bonds as compared to equity in your portfolio.
Moreover, if you have a considerably larger length of time at hand, you can opt to create an appropriate balance of equity and bonds. For a person aged 30 and creating a retirement investment plan, choosing more equity stocks can be wiser than safely opting for bonds and other low-risk options. Longer time horizons allow the portfolio to recoup the losses in the long-run and, thus, promote riskier funds. Ideally, the perfect portfolio of a long period will imply a 60:40 investment strategy for a high risk-taker, implying 60 percent of investments in stocks or equity and 40 percent in bonds. The riskier an investment, the higher are the chances of price fluctuations and also default.
Your financial standing in terms of available balance can greatly affect your risk tolerance. The more money you have, the riskier investments you can opt for in your portfolio. The amount of capital you can afford to lose is directly proportional to your risk tolerance. It is a realistic assessment, which helps you to invest only as much money that will eventually not affect your financial stability or cause any future liquidity problems. It is always advisable to stick to investing your discretionary income rather than disposable income in the stock market. The majority of monetary funds should be used to swell up safer investment options.
Once you have assessed your standing concerning the two critical aspects, you can study your investment portfolio and see where you stand in terms of risk.
- Very risky investments include options, futures, collectibles and more. Even though these account for maximum volatility, they are also the most rewarding.
- Risky investments include real estate funds, mutual funds especially high interest bonds and large or small cap equity. These investments are subject to a medium to high volatility with a substantial reward.
- The last category is of low-risk investments which are considered the safest but offer limited returns. These include Government debt bonds, Certificate of Deposits (CDs), notes, bills, bank accounts, cash and cash equivalents.
Overall, a low-risk portfolio ideally has 15-40 percent of equity holdings, while the mid-range risk zone has 40-60 percent and a high-risk portfolio has more than 60 percent of equity investments. The applicability and suitability of the risk levels vary significantly from person to person.
This categorization will help determine the block of investments that typically comprise your portfolio. If you have more investments in futures and options, and some distributed in stocks, you are in a very risky zone. Even though the chances of your rewards and returns in such cases are higher, this is only fruitful if you have a long-investment time horizon and a stable financial balance. Moreover, for a person who has more investments in government bonds and the remaining in the form of cash equivalents, the investment portfolio is in minimum risk but also a minimally rewarding zone. This strategy works best for people who are closer to retirement or need to withdraw money in the short run. But it completely boomerangs for someone who is young or has a high-risk appetite due to strong financials or a longer time horizon in hand. For example, for person X, who is investing at the age of 30 with an aim to purchase a house at the age of 50 or more, a typical investment portfolio should have more risky assets rather than stable ones. Otherwise, the ultimate objective of investment, which is to allow the money to grow at its full capacity, will be defeated.
Thus, the level of risk in a portfolio can be determined based on the allocation of assets. More allocation towards the high-risk or mid-risk asset class implies an elevated risk portfolio and vice versa. However, there is no standard model for each investor, and the strategy should typically be based on the above two factors – time horizon and balance. As a general piece of advice, with age, the portfolio should be less risky and have more stable income assets, as the goal during later stages of life is more directed at capital preservation than huge profits. On the contrary, for a person in their early 30s with more than 30-35 years left to retire, investment in riskier and rewarding assets should be the main approach of investing.
For an investor aiming to de-risk their portfolio at any given time, the following strategies can be useful:
Relate the risk to life stage
A person in the early stages of life has more risk-taking capacity, and hence, a portfolio with more allocation in equity can function well for them. But a person who is supposedly at the age of 57 and is close to drawdown in another 7-10 years, risking asset allocation in equity might not be the ideal scenario since the aim should be stabilized returns with capital preservation at this stage of life. However, it is also not wise to completely shed the portfolio of stocks and convert fully into bonds. Instead, a healthy balance of both with equity in a more defensive role is the best way to invest with age.
Opt for smooth de-risking
A sudden knee-plunging strategy to shift all stocks into safer investments may not be the ideal way to de-risk a portfolio. Hence, one must adopt a disciplined approach and take monthly or quarterly installments and shift them into non-volatile contributions.
Choose your de-risk mode
Reducing risk in a portfolio can be either done actively or passively. In the former, the investor chooses to monitor market forces consistently and actively rebalance assets as per vitality. On the other hand, passive mode involves making a protection plan for other automatic asset allocation covers that modify the portfolio based on age, goal, investment period, and the overall risk tolerance of the investor.
To sum it up
At every stage of investing, you must consistently monitor the financial market and the performance of your portfolio. Moreover, with each phase of life, it is critical to assess how much risk is tolerable and what is the overall objective of the portfolio to ensure that you cautiously meet expectations and set goals. The risk tolerance of an investor is the fundamental force governing portfolio investments. While it is essential to understand securities, it is also very crucial to know your risk-taking capacity, requirements, and financial situation. Active allocation of assets and age-related investment strategies can significantly help to balance the risk as per the current need.
For an in-depth assessment and professional advice on de-risking, you can consult financial advisors.