Risk Tolerance for Investing

Finding your risk tolerance is important since it’s your risk tolerance for investing and time horizon that are used to forge your customized investment plan. A common mistake is making your investment plan too risky. If you do, there’s a chance you won’t stick with that more aggressive plan during the next big market downturn and bale out of those risky investments at the worst possible time.

Aggressive investors must accept the ups and downs and the occasional bubble, with the outlook that in the end that higher per-year return will prevail. More conservative investors are much more sensitive to volatility and would rather take a slower approach to wealth building. They are less confident that the markets will behave as they have in the past and are more concerned with preservation of capital then with double digit yearly returns.

Whose approach will win out and produce the best results? Only time will tell. Find your place somewhere between the two extremes: super-conservative and super-aggressive. Mess with your allocations until they feel just right. One way to help is by researching target funds.

Target Date Funds

The companies who run target date funds (Vanguard®, Fidelity®, T. Rowe Price®, Schwab®, etc.) would love for you to invest in their target funds. One way they try and entice you to invest with them is giving you free and unfettered access to their prospectuses. You don’t need to have an account or even leave your email to gain access. After a few clicks, you’re in.

That prospectus tells you exactly how your money would be invested if you chose to invest in that plan. In fact, it will list risky to not-so-risky ratios for next year as well as all subsequent years and fifteen years into retirement. That prospectus will even show how your dynamic diversification would be broken down by percentage for market cap and investing style.

Be sure to examine the age-appropriate funds. When looking at target date funds for retirement, for example, choose the fund that has the year in its title that most closely approximates your projected retirement date. Keep in mind there are target date funds for goals other than retirement, so you can use this research technique whatever your financial goal.

After reading a few of them, you’ll see some plans are markedly more aggressive than others and creating investment plans is not an exact science. You’ll also start to get a better feel for what your own numbers should look like.

Lie About Your Age

Target date funds are often a poor fit with investors because they don’t consider an investor’s risk tolerance for investing, only time horizon. That’s why you always need to read the prospectus before investing to see what you’re getting into. One way to increase or decrease risk when examining target date funds’ allocations is to lie about your age.

Say you like a particular fund’s plan and would like to mimic it but would like to see it a little less risky. Pretend you’re older than you are and examine the target date fund with the next biggest number in its title. That less risky plan just might be the perfect template to follow.

If you wish a particular target date investment plan was more aggressive, lie again and pretend you’re younger than you really are by choosing the next lesser number. Now you’re looking at a plan that’s more aggressive.

Manage Your Own Plans

If you’ve read this far, you probably aren’t interested in investing in a target fund: You want to manage your own plans. That’s great, because you’ll be saving the extra fees target funds charge when compared to you compiling and managing your own plan. Still, the prospectuses of these target funds are a great resource to get a handle on your own risk tolerance for investing.

When I say do it yourself, I don’t mean investing with individual securities. You’ve probably got better things to do than following the daily ups and downs of upwards of 40 companies, which is what’s needed for any semblance of diversity.

Does that mean I don’t own individual stock in my own investment plans? No. There are a handful of companies. Many of them are ones I came to know through my financial career, either directly or indirectly, and I enjoy reading the information released by them like quarterly reports and well as information from other sources. Obviously, I also believe they have excellent upsides.

If you own individual stock, including your employer’s stock, there’s a good chance you own shares of it elsewhere in your investment plan, like in index mutual funds and/or exchange traded funds (ETFs) that are part of your diversified portfolio. Integrate those individual holdings into your plan with those other investments, and make sure you don’t own too much of any one company.

Index Mutual Funds and ETFs

Invest most of your money in index mutual funds and ETFs. I’m always on the lookout for a strong performing actively managed fund, one that clobbers their true benchmark index year after year. Unfortunately, they are few and far between, so I personally invest in just a smattering.

Look for passively managed funds that duplicate the performance of their benchmark index year after year and do it at a very low cost. Use only no-load index mutual funds and trade-free ETFs.

With a no-load index mutual fund, your only cost of investment is the expense ratio of the fund, and that cost is built-in to the trading price of the mutual fund. If you see other charges like redemption fees, front and back-end loads, and the dreaded 12b-1, get out of there fast and look elsewhere.

These days you don’t have to pay brokerage fees to trade ETFs, so don’t tolerate it. Like index mutual funds, look for ETFs with the lowest expense ratios and effective benchmark index duplication.