How Risk-Tolerant Are You? 4 Key Questions That Help You Decide
April 15, 2015 | Your Finances
Whatever your financial goals may be, if you are building assets over time there is a good chance your portfolio includes investments. But, are they the right investments, is what you should be asking yourself. One of the first steps in structuring a personal financial security plan is to determine your comfort level with risk to ensure your investments are aligned properly.
Finding the Right Mix
Two key tenets of Northwestern Mutual’s investment philosophy are to solve your risk-based needs first and develop an investment approach that is consistent with your risk tolerance, time horizon and goals. Your personal financial security plan integrates both insurance and investments and identifies the asset classes and allocations best suited to your needs, based on your risk tolerance. The plan would protect against risk with products including permanent life insurance and annuities, and help accumulate for future goals with an investment portfolio based on the recommended asset classes. Within those asset classes, your assets would be invested in appropriate financial vehicles including stocks, bonds and mutual funds.
A financial professional may use a tool called the Personal Investor Profile to guide a discussion on your attitudes toward risk and investing that explores the following areas:
1. What is your primary goal for the assets? If you are simply looking to preserve your principal or maintain what you’ve invested, this involves minimal risk. The level of risk increases as you seek to grow your assets and generate more income. At the high end of the spectrum is capital appreciation and growth, which can involve significant risk.
2. When do you want to access your funds? In general, the longer your investment timeframe, the more risk you can take on. Investing over the long term, such as 10 to 20 years or more, can accommodate more risk because there is more time to recover from market dips and adjustments. On the other hand, if you’ll need your funds in three years or less, you’re more likely to choose assets that minimize risk.
3. How long will you be withdrawing from this investment? As you consider funds that will be used for your retirement income, think about whether you’ll want to receive the money in a one-time lump-sum distribution, regular payouts over a period of years, or guaranteed for a lifetime. The structure of your investments could change depending on the type and timing of the disbursements.
4. If you could increase the opportunity to improve your returns by investing in riskier assets, how much risk would you be willing to take? You take a personal temperature check about risk by asking yourself if you’d be comfortable taking a small amount of risk with some of your money or most of your money, taking a moderate amount of risk with some or most of your money, or substantial risk with all of your money.
The process also includes reviewing hypothetical risk and investment return scenarios to determine your comfort level with various levels of volatility and the amount of your assets you may be willing to assign to higher risk investments.
Your Model for Asset Allocation
Your asset allocation strategy, which designates asset classes based on your risk profile, typically will fit into one of five asset allocation models:
- Conservative – These investors tend to be more interested in preservation of principal, liquidity and income, rather than in long-term growth or capital appreciation, and are willing to accept lower returns for the potential to reduce volatility. (Asset allocation: 20% risk, 80% fixed income)
- Moderately Conservative – Interested in preservation of principal, liquidity and income, these investors also seek modest growth in the value of their investments. They are willing to take on a little more risk to achieve that growth, understanding it may increase volatility. (Asset allocation: 40% risk, 60% fixed income)
- Balanced – Balanced investors are equally interested in preservation of principal and long-term growth. They generally want steady and sustained growth without the volatility that high-risk investments can bring. (Asset distribution: 60% risk, 40% fixed income)
- Aggressive – Primarily interested in long-term growth, aggressive investors are willing to take reasonable risks to achieve it. They are comfortable with the volatility that accompanies higher-risk investments. (Asset allocation: 80% risk, 20% fixed income)
- Very aggressive – These investors are interested in higher potential growth with greater volatility, and are willing to take substantial risks to achieve it. (Asset allocation: 100% risk)
Understanding your risk tolerance is one of the building blocks of your financial security plan. It is the basis of your initial asset allocation and can be updated as your personal circumstances change. And when market ups or downs make it appropriate to rebalance your portfolio, your risk tolerance will continue to guide the investment choices you make. Contact a financial professional to start the conversation today.
Notes: The recommended allocations in each asset allocation model currently contain up to nine asset classes including US Large Cap, US Mid Cap, US Small Cap, International Developed, International Emerging, Real Estate, Commodities, Fixed Income and cash alternatives.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. No investment strategy can guarantee a profit or protect against a loss.