This is a multi-part series on understanding your risk level. Be sure and read PART 1.
Most people can pick a risk level. For most, a risk level will speak to them. They might see themselves as a person who takes a balanced risk. They might see themselves as a person who is conservative or takes significant risks. Now you have to go through Step 2. So I have picked a risk level. Is this the right one?
Step 2 involves assessing your risk level based on two different questions. First, you have to answer the question - Can I live with the loss potential? After all, there is a gain/loss factor associated with 4 of the five risk levels. As a review, the risk levels outlined in Part 1 are aggressive growth, growth, moderate, conservative, and safe money. Second, are my retirement goals congruent with the level of risk that I am willing to take? If you need to earn 8% or above, are you willing to deal with the loss potential that accompanies attempting to achieve that growth rate?
Can I live with the potential loss associated with my risk level?
This is the research that most people don't do. While looking at potential mutual funds for a mutual fund portfolio, it is important to be comfortable with the amount of risk that the fund is taking. If you are working with an adviser or a mutual fund company, they will be able to get you this information. We, fortunately, have the financial crisis to assess how your particular mutual fund held up. These are the questions you should be asking:
What was the total loss of the fund during the financial crisis? You should be able to accept up to a 20% loss if you invest in mutual funds taking risks. Then, how long did it take to make that loss back up? Is that reasonable? If it only took less than two years to make it up, that is pretty good. However, if a real conservative fund took four years to make up a big loss, that would be troublesome. This is an excellent exercise to go through. (note: using the financial crisis as a benchmark is a good exercise. However, be mindful that past performance data does not guarantee a repeat)
Now, what if your mutual fund was not around during the financial crisis? Well, you have to determine if you are comfortable with a fund that has not been battled tested in the financial crisis.
Will your portfolio of mutual funds help you achieve your goals?
In order to achieve your goals, there is a certain average growth rate of your investments. Are you taking the right amount of risk that would be required to help achieve your goals? For example, say you belong in a conservative risk level. The target growth rate for that level of risk is 5 to 6%. Let's say that you need 7% as an average growth rate to get to retirement. Are you willing to increase your risk level or rearrange your goals so that they are congruent with the risk that you are comfortable taking?
Here is what I am not saying. Just pick a risk level and make your goals congruent, and everything will work out. It is not a slam dunk process. There is still a risk management aspect that is involved. This brings me to tomorrow's part III - How do I manage risk? If you want a more in-depth look at your risk level, go to this link and take our risk survey. It takes just a few minutes. I will then send you a risk analysis explaining your risk level and what to be mindful of when investing money.