While we can do a great deal to mitigate risk, we cannot eliminate it. Nor would we want to, for risk is related to expected return. In any investment plan, it is important to recognize and appropriately manage the types and the amount of risk you are taking. This will greatly increase your ability to adhere to your long-term investment plan, which serves as your roadmap to guide you toward your financial goals.

The right level of risk for you depends on both your personal preferences and your situation. We break the risk equation into the following four parts:

Part 1. Risk Tolerance: Your Willingness To Take Risk — Over time, the value of your portfolio will rise and fall. While we would always rather see our portfolio value rise, a prudent investor knows to expect periods, sometimes quite lengthy, in which the value falls. Equity markets, in particular, can be highly and unpredictably volatile.  

Your risk tolerance describes your level of comfort and ability to wait through the downturns. If you can tolerate the risk, then you will be able to maintain your investment strategy through both strong markets and weak ones, and remain true to your long-term vision. If the risk is more than you can stomach, it may cause you to abandon your carefully crafted plan.

Part 2. Risk Aversion: Your Ability To Take Risk — Designing an appropriate investment strategy requires balancing factors that can be in conflict. Your tolerance for risk may be high, but as a prudent investor you should also consider your ability to withstand financial losses. Because market downturns are unpredictable, you need to assess the real economic harm you might face if your portfolio seriously declined in value.

In other words, what would happen if market risk demonstrated itself and, as a result, the value of your portfolio dropped 5, 10 or even 20 percent, perhaps for an extended period of time? How would this impact your ability to stay the course and remain adherent to your long-term investment plan? What measures would you be able to take (such as postponing retirement or saving more) to make up for the downturn? Would you have the ability to withstand the decline if required to do so? If not, we may need to consider building and maintaining a less risky portfolio.

Other factors that may affect your ability to take risk include your time horizon and your income source(s). For example, if you have a very long time horizon, you may be better able to withstand lower-than-expected returns when they occur. Inflation also needs to be considered in the construction of your portfolio to ensure the expected growth of your portfolio is enough to compensate for inflation’s damaging effects. Likewise, the potential overlap of the risks to your sources of income and your investment portfolio should be reviewed and addressed.

Part 3. Risk Avoidance: Your Need To Take Risk — Most investors would not choose to take more risk than is necessary. While this is a simple statement, investors often fail to build this concept into their portfolio planning.

Your need to take risk is directly tied to your rate-of-return objective. If you need your portfolio to grow more quickly over your time horizon, you will require a higher rate of return. However, an increase in your rate-of-return objective will generally mean taking more risk. If your higher return objective is inconsistent with your risk tolerance (willingness to take risk) or your risk aversion (your sensitivity to losses), then you must consider adjusting one or more of these parameters. This could mean, for example, retiring later, subjecting yourself to the possible discomfort of greater risk, lowering future consumption or net worth expectations, or increasing your savings.

On the other hand, if your rate-of-return objective can be lowered because your assets can support your goals with less growth, then your need to take risk is reduced and your portfolio should be allocated accordingly. As your portfolio grows over time, your need to take risk should be reassessed and your asset allocation adjusted accordingly.

Part 4. Your Tolerance for Tracking Error: What If Your Portfolio Looks Different — Many investors are more comfortable when they know they are doing at least as well as or no more poorly than most other investors. A portfolio that tracks the returns of a popular index such as the S&P 500 Index can provide that comfort, despite the fact that it may not provide the risk management or higher expected returns that may be available from an effectively diversified portfolio.

Tracking error is the amount by which the performance of a portfolio differs from that of applicable major market indexes. You should understand your personal tolerance for the tracking error that can result from a portfolio that purposely diversifies away from popular indexes to decrease volatility and increase expected returns. Bear in mind that tracking error can be present for lengthy periods. For example, if your portfolio is weighted heavily toward riskier asset classes with higher expected returns, it can often look quite different from the closest comparable index. The difference can be positive or negative, and may be present over many years.

Rate of Return Objective

Every investment choice you make involves a tradeoff between risk and return. In general, the less risk within your portfolio, the lower its growth potential — and vice-versa. To increase the expected rate of return for your portfolio, you will typically have to take more risk. Thus, your rate-of-return objective must match the realistic opportunities that you have, given your time horizon and your risk profile. If your rate-of-return objective is higher than your time horizon and risk profile permit, then you must adjust at least one of the three parameters.

All else being equal, most people would prefer to have a higher expected return. In particular, if two portfolios were equally risky, but one offered a higher expected rate of return, then you would logically choose the portfolio with higher expected reward for your risk.