Knowing your risk tolerance is an important factor in investing. Some investors are willing to take big risks with the potential for big rewards. Others prefer to minimize their losses, even if it means smaller returns.
What Investment Risk Tolerance Is
When it comes to investing, understanding risk tolerance involves the following three factors:
- Your risk capacity: This is your ability to handle risk financially — the amount of money you can afford to lose without impacting your financial security. How close you are to retirement and the financial obligations you have will affect your risk capacity.
- Your needs and wants: These are your goals for your finances and your lifestyle. For instance, maybe you want to retire soon or save up for a down payment on a new house.
- Your emotional risk IQ: This is about your personality and how you see risk. You might be a thrillseeker who likes to live on the edge. Or perhaps you prefer a sure and steady approach.
First, of course, there are the goals you’re saving and investing for. Is it retirement? A down payment on a new house? Sending your kids to college? Where your money is going will make you more or less willing to take risks for the potential of higher returns.
Your time-frame is another major factor. If you plan to retire in a few years, you have less time to recover from possible losses, so you’ll likely take a conservative approach to investing. You need your money to be there so you’ll have income to live on in your golden years.
But if you’re a newbie investor in your 20s, you have decades ahead of you with plenty of time to recoup any losses. In that case, you may be more aggressive with your investments to try to maximize your returns. And if you fall someplace in the middle of these two groups, time-wise, you might favor a more moderate investing strategy that balances risk and reward.
Your income is also very important. If you expect your income to grow, you may feel freer to take risks. But if your income is uncertain — maybe you’re a freelancer, for instance — or you don’t anticipate your salary to grow, you might be much more cautious with your money.
Finally, there’s your temperament. If you invest in stocks, for example, are you going to be filled with anxiety every time the market dips? Or are you more or less unflustered by swings in the market?
Thinking about these different factors can give you some insights into your feelings about money.
Finding Investments That Match Your Risk Tolerance
With this new knowledge in hand, you can invest your money in a way that makes sense for you and the amount of risk you feel comfortable with. These are some scenarios you might want to think about, depending on your investment style.
- Conservative: A conservative investor may opt for a portfolio that mainly consists of funds that tend to be stable and lower risk, such as money market funds and government bonds.
- Moderate: An investor who takes moderate risks might choose to balance their portfolio between riskier assets like stocks and more stable investments like money market funds and bonds.
- Aggressive: This type of investor will likely gravitate to assets with a high potential for return, but also a higher potential for volatility and loss, such as growth stocks and options trading.
Whatever your risk tolerance is, it’s wise to diversify your portfolio across different asset classes including stocks, bonds, and commodities.
The Takeaway
Each investor has a risk tolerance level depending on their individual circumstances. A risk tolerance quiz can help you evaluate how much risk you should take.
That said, it’s vital to know that all investments come with some degree of risk. A conservative investor will likely feel better with lower risk investments, while an aggressive investor will typically look for assets with high growth potential, despite the higher risk they pose.
Once you have investments that suit your style and temperament, the better you may feel about your investment strategy. Just be sure to check your investments regularly to make sure they’re on target to get you where you need to be to meet your financial goals.
This article originally appeared on SoFi.comand was syndicated by MediaFeed.org.
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How good are robo-investors at picking investments?
We’ve all seen the movies where robots try to take over the world disguised as humans, use humans as living batteries, smooth-talk red lights, or try to jettison astronauts into outer space.
And this might lead you to question whether robots have your best interest in mind. Yet, far from the drama of Hollywood, robo-investing — which provides investment advice and management with limited human intervention — can be a useful, low-cost financial tool to help you reach your goals.
Related: Robo advisor vs. financial advisor: Which should you choose?
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Traditionally, an investment advisor would work with you to build an investment portfolio, helping you choose an allocation of stocks, bonds and other investments, and periodically rebalance them as the market and your needs change. All of this human interaction makes traditional investment advising fairly pricey.
A robo-advisor, on the other hand, uses computer algorithms to build and manage your investment portfolio — often using low cost index and exchange-traded funds — with limited human interaction.
Cut out the human managers and the price for investment services goes down considerably. In part due to their low cost, robo-advisors are becoming increasingly popular. In 2017, robo advisors passed the $200 billion mark in aggregate assets under management, and that number is likely to keep growing.
What’s more, many robo-advisers may offer low or no investment minimums, which means you can start investing any time.
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Some robo-advisors charge fees on a per-trade basis, while some charge fees based on a percentage of your portfolio value. While traditional advisors typically charge a fee of around 1% of assets under management, robo-advisors’ fees range from 0% to 0.89% with fees typically hovering around 0.25% to 0.30%.
The fees charged by robo-advisors are important to pay attention to even if they seem low. Consider that a 0.25% fee reduces an annual return of 7% to 6.75%. This reduction may not seem like much, but over the course of many years, these fees start to add up.
Additionally, the use of low-cost index funds and exchange-traded funds tend to drive the cost savings even higher. In 2017, the average expense ratio of a passive investment (such as an exchange-traded fund) was .15% compared to the average expense ratio of .72% for actively managed funds.
When you add these two components up, the average robo-advisor using passive investments could be 1.32% less per year than the average human advisor using actively managed funds. As balances grow over time this can have a fairly substantial impact.
This is all to say you should carefully weigh fee options against the services different robo-advisors offer to make sure that the fees you are paying are worth it to you. For example, a slightly higher fee might give you access to a human financial advisor who can offer you investment advice. If that kind of service is important to you, it might be worth paying a little bit extra.
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Aside from the fees you’ll pay, there are a number of other factors worth considering when you’re deciding whether a robo-advisor is right for you, including:
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Most robo-advisors use a mix of ETFs and low-cost index funds. ETFs hold a basket of stocks or bonds and are built to mirror an index, such as the S&P 500. They are traded throughout the day. Index funds are mutual funds that also hold a mix of investments and track an index.
Mutual funds only trade once per day. Both types of investments are more diversified than an individual stock because of the basket of assets that they hold. When choosing a robo-advisor make sure that they offer the types of investments that you want to include in your portfolio.
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You’ll typically be offered two broad types of accounts when you consider a robo-advisor: a retirement account or a regular taxable investment account. A standard investment account has no limits on the amount of money you can invest.
Retirement accounts, such as IRAs and 401(k)s offer specific tax advantages.
Be clear about your goals when you choose your account type. If you’re saving for retirement, the tax advantages of retirement accounts are hard to beat.
But if you’ll need access to the money sooner than that, consider a regular taxable account. You don’t want to be slammed with the early withdrawal penalties that come with dipping into retirement accounts too early.
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Robo-advisors usually offer a fixed number of portfolio options designed to cover various levels of risk. The robo-advisor will typically recommend one of these portfolios based on your goals, investment preferences, comfort with risk and time horizon. Robo-advisors will usually match you with a portfolio by giving you a questionnaire.
This questionnaire doesn’t lock into a portfolio, so you might be able to override the default selection to choose a portfolio of your choice.
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Once you’ve signed up for an account with a robo-advisor, you will typically be offered a range of automated services.
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Based on the process described above, let’s assume you were placed in an allocation that consists of a mix of 60% stocks and 40% bonds. Over time this allocation will likely shift a bit as investments fluctuate based on the movement of the market.
For example, the stock market may grow faster during a particular period of time than the rest of your portfolio. Rebalancing helps you buy and sell assets to realign the investments inside your portfolio to the desired allocation.
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Many robo-advisors make it easy to establish sound financial habits, such as ongoing saving, by establishing recurring contributions. A common example of recurring contributions is in an employer sponsored plan such as a 401k. The value of recurring contributions is that it automates the tough decision of saving for the future. This strategy is not just limited to your 401k, and might help you be more disciplined with your other accounts.
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Some robo-advisors combine the cost-effectiveness of technology with the expertise of humans by offering access to financial professionals. This hybrid approach might enable investors to ask questions, discuss goals and plan for the future. Robo-advisors might charge for this service, but it tends to be optional if it is offered.
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There are some potential drawbacks to the one-size-fits-all approach of robo-advisors.
Those interested in investing in complicated assets, such as real estate investments or trusts, may want to look to professionals for help doing so.
That said, robo-advisors can be a great financial tool, especially for those who are just starting out investing and who don’t have complicated investment needs.
For example, Millennials who are still accumulating assets may find that robo-advisors are a good fit. The low cost of robo-advising has lowered the barrier to entry for many investors, giving them access to tools once reserved for higher-net-worth individuals.
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
Learn more:
- What does a wealth management advisor do & how can they help you?
- What exactly is an automated advisor?
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