Are You Taking on Too Much Risk?

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Are You Taking on Too Much Risk?
by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.
October 12, 2009

Key points

To best achieve your investing goals, take a look at your current asset allocation, realistically evaluate your risk tolerance—and make sure the two are aligned.
There's no shortcut for a careful examination of your unique tolerance for risk—it's not as simple as age or appetite for risk in your occupation or hobbies.
If you have limited experience or need help determining your risk profile, learn why honestly figuring it out and matching it with how you invest is so important.

Last year was a stark reminder of risk. It would have been natural to question the level of risk in your portfolio, given that the returns for most asset classes were double-digit negative. Times like this can really serve to teach you about your personal risk tolerance.

If you sold out or altered your portfolio significantly in reaction to the market, it's likely you were taking on too much risk and may need to revisit your long-term plan, including savings rates, time horizon, expected withdrawal rates, inflation and, most importantly, a progress update versus your goal.

Appetite for risk sets your course
The foundation of investment planning is a proper asset allocation plan, which drives security selection, monitoring and projections for meeting your goals. The key driver determining your asset allocation plan should be your risk profile, or tolerance for risk. There are many important factors to consider when determining your risk profile, and doing so honestly will help you choose the best plan to achieve your financial goals—while maintaining your peace of mind. See the sidebar at right for articles that can help you determine your true risk tolerance, reduce your risk without reducing returns and diversify your investments.

Over the past few decades, with the introduction and increased popularity of 401(k) plans, we've seen a shift from the traditional pension plan—which assumed and decided the level of risk for all participants—to individual workers being forced to make that decision. Given the importance of risk tolerance, you'd think it would get more prominence in the decision-making process.

However, many investors don't give their risk tolerance much thought and arrive at their asset allocation through a collection of one-off decisions to buy this stock or that mutual fund. Many people invest more time buying furniture or choosing the right car. Yet they'll be depending on their investments long after that old chair is gone or that new car becomes an antique. You should take a look at your current asset allocation, realistically evaluate your risk tolerance—and make sure the two are aligned.

Determining risk tolerance
Understanding market history can help put things in perspective. Knowing how a plan like yours has performed in various markets historically is a good starting point. Ask yourself: what's the worst possible year a plan like mine might have—and could I maintain my plan in such an environment? If the question makes you squeamish or the answer is no, then it's time to re-evaluate.

Although history can be a good guide, there's no replacement for experience. Unfortunately, investing is still relatively new to many investors: in 1989 less than 33% of US households invested in the stock or bond markets, though that number had increased to 47% in 2008, (down from its 2001 peak of 57%), according to a 2008 survey by the Investment Company Institute and the Securities Industry and Financial Markets Association. This translates into almost 20 million new households entering the market since 1989.

Another consideration is your capacity to withstand risk, which could be tied to your age and/or time horizon for your goal. If you have a longer time horizon, you may be able to withstand more risk. However, be careful here: risk tolerance can often be like a personality trait—it doesn’t change dramatically over time. Don't take on more risk just because you have a long time horizon if you truly won’t be comfortable with the ups and downs of the market.

For those in or nearing retirement, it's important to determine if you have enough to live off of a portfolio consisting mostly of bonds. If so, there's no need to take on much equity risk. On the flip side, given how long many people are living after retirement, you may need more stocks in your portfolio than you may think. The retirement article at right can help you explore these issues.

There are downsides to not having your asset allocation aligned with your risk tolerance:

It'll be difficult to plan for your goals accurately. If you don't have an idea of the return you could generate from your portfolio, which is closely connected to the risk level of your portfolio, then planning is difficult. But don't blindly assume that taking on more risk will ensure that you reach your goal—you need to understand that taking on more risk is just that—riskier.
There's a greater likelihood of abandoning your plan. To be a successful investor who sticks with your plan through the market's ups and downs, you need an understanding and comfort level with how your portfolio might perform. Many people abandoned their plans during the recent bear market—investors who'd bought stocks without a greater understanding of the risks involved cracked under pressure and sold as the stocks were falling. They were reactively adjusting their portfolio based on market activity rather than proactively creating a plan and sticking with it.

Risk tolerance is personal
People often mistake one’s occupation or age for their risk tolerance. Some people with very high-risk occupations or hobbies may be very conservative investors. Some older investors can be aggressive, while other younger investors could be conservative. There's no shortcut for a careful examination of your unique tolerance for risk.

The concept of risk is so important that most institutional investors like pension plans and foundations have structured investment policy statements that lay out their risk tolerance and can be referred to when making future decisions—perhaps not a bad idea for individuals to incorporate.

If you have limited experience or need help determining your risk profile, Schwab's investment professionals can help. They're well versed in discussing and helping clients determine the risk profile that's appropriate to their unique situation.

So add some discipline to your investment process: Determine your risk tolerance—honestly—and occasionally revisit it to make sure your portfolio is properly aligned.

Important Disclosures

The Schwab Center for Investment Research® is a division of Charles Schwab & Co. Inc.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies and the securities shown may not be suitable for you. We believe the information provided is reliable, but Charles Schwab & Co., Inc. (“Schwab”) and its affiliates do not guarantee its accuracy, timeliness, or completeness. Any opinions expressed herein are subject to change without notice.

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