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Aug 28, 2018

How Knowing Your Investment Risk Profile Can Ease Investment Anxiety

By Stash Team

Visual learner? Watch this to learn everything you need to know about risk profiles.

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Does the thought of investing leave you worried or anxious? If that’s the case, you may not be alone. Investing has its risks, and there’s always the chance that you could lose money in the market. Every investor can tolerate a different amount of risk—and just how much risk depends on a number of factors. The level of risk you’re comfortable with is known as your risk profile. And knowing your risk profile can be helpful in building the portfolio that suits you best.

Risk profiles: the tl:dr

 

Risk profile vocabulary

Let’s start with some definitions:

  • Investment risk is the degree of uncertainty of your investment’s future returns
  • Risk tolerance is how much risk you’re willing to tolerate, and it’s usually grouped into three levels: conservative, moderate, and aggressive

Risk tolerance factors

So, what determines whether your risk tolerance is conservative, moderate, or aggressive? There can be a lot of factors; here are a few common ones:

  • Your age
  • Your income
  •  Your saving goals

For example, if you’re young, you may be thinking about your financial future over the long term. That might mean you may have more tolerance for the risk of losing money in the short term if you think long-term gains are possible. On the other hand, if you’re approaching retirement, more short-term risk could be outside your comfort zone.

If your budget is tight, or you don’t have much income left over after your expenses, you might feel more comfortable avoiding investments that have a higher degree of uncertainty regarding their future returns—or you might prefer to invest a small amount of money in an investment that you believe will pay off in the long run. On the flip side, if you feel like you have plenty of money over and above your living expenses, you may feel like you can tolerate a higher risk investment.

Your savings goals might also affect your risk tolerance. Depending on how much money you want to save up and how long you plan to work toward that goal, you might optimize your portfolio for short-term returns, long-term gains, or another outcome you hope to achieve.

It’s likely that you won’t determine your risk profile by looking at any one factor in isolation. Ultimately, risk tolerance is usually determined by an investor’s assessment of their financial big picture, including individual characteristics and financial goals. By looking at multiple factors and reflecting on the level of risk you feel you can tolerate, you can get a sense of your own individual risk profile—and that can help you decide on the investing strategy that feels right to you.

Risk profiles: conservative, moderate, and aggressive

If your risk profile is conservative, you probably prefer stability, even if it means smaller gains—but you want to see some growth potential too. Here’s a typical conservative risk portfolio:

  • About 40% stocks
  • About 60% bonds

If your risk profile is moderate, you’re likely looking for long-term growth potential (which may include slightly more risk of losses in the short term), but you still want some amount of stability. A moderate risk portfolio commonly contains:

  • About 60% stocks
  • About 40% bonds

If your risk profile is aggressive, chances are you want to maximize your portfolio growth in the long run, even if it means sacrificing stability in the near term. Your aggressive portfolio might look like this:

  • About 80% stocks
  • About 20% bonds

Investment mix and risk profile

You can see that the more aggressive the risk profile, the higher the percentage of stocks in our example portfolios. Conversely, the percentage of bonds increases when a risk profile grows more conservative. But why?

Over the long term, stocks may offer relatively higher returns. Since 1926, stocks for major corporations have had average return rates of 10% annually. However, that’s just an average over time; stock prices can rise—and fall—very quickly. As result, they are perceived as more volatile (that is, more likely to change) in the short term. Hence, a higher proportion of stocks can make sense for an aggressive risk profile. 

Bonds, on the other hand, tend to be less volatile. Unless the bond issuer defaults, investors receive a fixed return on their investment. That said, the long-term returns may be lower for bonds than for stocks. Government bonds, for example, have returned 5-6% annually since 1926. So more bonds in the portfolio could offer more stability, which might be what those with a more conservative risk profile are seeking.  This article offers a more comprehensive discussion of the types of investments listed in the risk profiles above. You can also learn how stock and bond prices relate to one another in this article.

What’s your risk profile?

Thinking about your situation and your financial goals may help you build a portfolio that more accurately reflects your risk tolerance—which could ease some of the worry about investing. When you reflect on your own tolerance for risk and your personal financial circumstances, you can get a sense of your risk profile. While there’s no way to eliminate risk in investing, it is possible to learn about how much risk a given investment may carry—and use that knowledge, combined with your risk profile, to make more confident and empowered investment decisions.

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