How much risk should you take when investing

As an investor, the amount of risk you take is possibly the single most important decision. Generally, more risk means more return over the long run. But like most things in life, too much can be dangerous to your financial health. Take on too much risk and you may lose a good proportion of your investment right before you need it. Likewise, take on too little risk and your money might not grow to the amount that you need—a type of risk that many investors don’t consider.

Only you can determine the level of risk that is right for you. But how do you do it?

Here are the three steps you need to take to find your answer.

Step 1. Determine and quantify your investment goals.

This first step is probably the most overlooked. When we speak to investors and ask if they have a goal, they often tell us to make as much return as possible. This approach will not help you. You need to be very specific.

Exactly why are you investing? Is it to fund a deposit for a house? Pay for private schooling for your kids? Or is it fund your retirement?

You need to answer this first and then put a figure to it.

For example, let’s say you want to fund your retirement. How much does fund your retirement mean? Maybe you want to earn $80,000 per year from your investments. You could assume a portfolio return of 8% which means you need a nest egg of $1,000,000.

Your investment goal, therefore, is to build your investment account to $1,000,000. This is what a goal looks like. It is specific and quantifiable.

Putting a time frame on it will also help a great deal.

Your goal should look something like “I want to grow my investment account to $1,000,000 in the next 15 years”

Step 2. Asses your risk capacity to determine general risk allocation

When we ask a question about investment risk most investors immediately think “how much could I lose?” But again, to truly understand risk, we need to put this in a time perspective.

Consider the question of risk when thinking about a stock such as Commonwealth Bank of Australia (CBA). In a single day CBA could potentially fall as much as 5 to 8% (in theory it could fall any amount, but historically this is a good assumption). But if we consider how far it can fall over the space of one year, then we are looking at 50%.

Stock indexes fell 50% in the 2000-2002 recession. They fell 50% again in the GFC. Covid has just shown us 50% is a good level to assume risk in large-cap stocks. Small-cap stocks could be a lot bigger.

Other asset classes have historically fallen less. You could assume for bonds and real estate a fall of 25% could happen. (providing you are investing in something decent and not below investment grade)

Cash risk is assumed to be zero (not quite true but good enough for our task)

You can come up with your own figures for potential falls. Then all you need to do is think about how a fall of this magnitude would impact your portfolio and, most importantly, the chance of reaching your goal.

Step 3.  Consider time frame.

Whilst asset price falls can occur in any investment, the key thing is to remember your time frame. For, even though we have seen falls of 50% in stock indexes in 2000 and 2008, eventually, stock prices have recovered.

Just because a fall occurs in an asset, it does not mean that is the end. The asset price could recover, provided you give it enough time.

Thinking about stocks (as that is our main focus here at Capital 19), we like to assume should a fall occur, then if you give the asset class 5 or 6 years it should have enough time to recover. If you look at the US stock market in the GFC. The S&P500 reached a high in November 2007. It then fell and had fully recovered by March 2013. The 2000 recession also took 6 years to recover.

Armed with this knowledge you can now compare your goal time frame to the recovery time frame. If your goal time frame is 6 or more years away, should a 50% fall happen today then you don’t have a lot to be concerned with. Whilst it might feel uncomfortable now, it should recover by the time you need the funds.

If the idea of a 50% fall keeps you awake at night even if your goal is longer, then the asset class is too risky for you. But risk and reward go hand in hand. If you don’t take enough risk then you might not get enough reward to achieve your goals and you are guaranteed to fail.

It is all about balance.

Controlling Risk with Asset Allocation

Asset allocation is one of the most basic, but essential, aspects of sound investing. Empirical studies have shown that perhaps more than 90% of a portfolio’s variability of returns can be explained by strategic asset allocation.

Think about that statement. 90% of the variability of returns can be explained by asset allocation. Not by stock picking. Getting your asset allocation right is extremely important. You could argue the most important.

The volatility that we saw over the first four months of 2020 as well as in early September has made choosing an appropriate asset allocation even more significant.

We will write more on this in the future…….