When you’re financial planning a lot of the conversation is going to focus on risk management. Risk levels are usually labeled as: aggressive, moderate, and conservative. Each level should be determined by your own investment objectives, your timeline, and your own gut instinct (yeah, sometimes investing isn’t exactly scientific).
Is there Any Real Risk?
Risk generally refers to the likelihood of your investment dropping. Whether you’re going through a firm, investing on your own, or just setting up an IRA through a robo-site, there is always risk. A common misconception is that risk refers to the chance that you’ll “lose everything,” that’s not going to happen unless you’re picking individual stocks, which most financial advisors suggest you avoid.
You can look into your broker’s annualized return average to get an idea of what their annualized net gain/loss is, but usually you’ll see a return hovering between 8-10% depending on your risk with maximum annual losses that hover around 15% for conservative plans, 30% for moderate plans, and up to 45% for aggressive plans. It’s important to know we’re looking at average returns versus maximum losses here. The odds of losing money are different and aren’t really predictable (be wary of anyone who tells you otherwise), so it’s difficult to give an “average” loss percentage.
What’s the Difference between the Levels?
The main difference between the levels is the proportion of where your investments lie. Most firms invest in stocks, bonds, and cash. There are some that now deal in crypto currency and real estate. Stocks, crypto, and real estate are all the most volatile and are the hardest to rely on. They offer the greatest losses and the biggest gains. Bonds are quite safe and have a guaranteed growth rate, their risk for loss mainly comes in the form of inflation. Cash is the safest and grows slowly, kind of like interesting in a savings account. Each level of risk rebalances the proportion of each investment type and might change the types of stocks/bonds your portfolio is invested in.
Aggressive Risk Tolerance - Knowing that the risk is very real, you might be thinking, why would I ever pick an aggressive portfolio? Well, that’s because investments compound. If you make money, you can then make money off of that money, it’s like a snowball rolling downhill.
In an “aggressive” portfolio, your investment will usually be divided with 70-80% in stocks, 10-15% in bonds, and the rest in cash. Since there is a heavy investment in stocks, this portfolio is subject to the whims of the market.
An aggressive portfolio is usually recommended for someone who is young and has the potential to make money back if there is significant market loss. It’s also fine for individuals who already have a safety net and thus have a higher risk tolerance.
Moderate Risk Tolerance – Risk is not like a bucket of popcorn, going moderate is not the same as getting a medium. In a moderate risk portfolio, you are still assuming some risk. The split hovers around 40-60% in stocks, 40-60% in bonds, and then the rest (if there is any) in cash.
A bad market and a rough economic slide could be just as risky for the moderate investor as it is the aggressive one, but since your investments are divided more evenly, you won’t be hit as hard if something happens to the market.
A moderate risk portfolio is usually a transition point for people to swap to as they get older. It is recommended for people who are getting older and thus have less time to recover if something negatively impacts their portfolio.
Conservative Risk Tolerance – If you’re nervous or have a large enough portfolio where you can live off the interest, then this option is definitely the best for you. A conservative investment strategy means you focus on cash and bonds, and have some safer stock options. The split ends up being around 20-30% stocks, 50-60% bonds, and 20-30% cash.
Having a more even spread means you’re protected from economic slides like the moderate plan, but even more so. Your returns are also way more predictable this way and are way less likely to lose any money. To be clear, even with the most conservative investment strategy there are still risks to lose money, the chance is lower and the amount you’d lose is lower, but it is still possible.
Ultimately, this plan is for people moving toward retirement or who are retired, but if you’re nervous about the state of things, it might be a good call to consider this option.
How do I pick a Risk Tolerance?
As always, it’s best to talk to a financial advisor before making these decisions (you know it’s serious because it’s in bold). There is no cookie cutter best solution. Proper financial planning depends on your finances, meaning you can’t just do what someone else does, every situation is different.
Once you’ve done that, there are plenty of online tools that can help you decide. Depending on where you’re building your portfolio, there might even be tools on that site designed to help you. Charles Schwab, Betterment, Fidelity, Ameritrade, and Fidelity are some of the most popular online investors, all of which offer tools to assess your situation and decide on your risk.
You can also do more research. My favorite financial sites are Investopedia and “The Financial Diet,” each are very straight-forward and offer information in a very digestible and honest way.
Here are some places to start:
Our Financial Planning Article
In this article, I talk directly with a financial advisor about general tips and approaches for anyone looking into investing. This is great for someone who doesn’t want to make investing a hobby, but wants to still do it.
How to Overcome Your Fear of Investing
This 11-minute video is a great introduction to investing that breaks down terms and ideas at a level anyone can understand.
Financial Diet’s Investing Playlist
If you have more specific questions or just want to learn more broadly, this playlist has some great videos all dedicated to how you can become a smart investor.
A Beginner’s Guide to Investing
Like most Investopedia articles, this is a great overview of the terms you’ll run into while you start journeying deeper into investing!
This article goes over how to manage risk in finance and is a great partner to the article you just read if you want to learn more.
Four Steps to Building a Profitable Portfolio
Check out this article to learn how to get started, just know that there are some strict regulations on providing a step-by-step process to start investing, so this is more general advice.
If you’d like to learn more, we have a full series of “Road to Retirement” articles too. Check out the list below.
Estimating the Cost of Long-Term Care
How your Benefits Translate into Retirement
How do you keep an Income while Retired?
Planning for Retirement while Young