What are Risk Management and Tolerance and How Do They Impact Your Investment Strategy

You may have heard before that investment returns are never guaranteed. This is the very foundation of investing—taking a risk for the potential to receive more than you put into it. For this reason, investors should consider their risk appetite when establishing or updating their portfolio. Implementing tried-and-true risk management strategies can also help offset the risks associated with investing. 

Let’s examine risk management and risk tolerance and their role in your investment strategy.

What Is Risk Management?

Financial risk management is relatively simple in concept—it’s the process of dealing with the risks associated with certain investments. More specifically, it involves identifying and analyzing potential risks, monitoring them, and deciding whether to accept them or find a way to address the associated uncertainties. 

Financial risk comes in multiple forms, but a few of the most common include:

• Market risk: Fewer people are looking to purchase stock than there are sellers.
• Credit risk: Also referred to as borrower’s risk, credit risk is the risk that a person will take on too much debt (borrow too much money) and be unable to pay it back. This type of risk impacts both lenders (missed payments impact projected income) and borrowers (default, poor credit, repossession, etc.).
• Cash flow liquidity risk: A business may not have access to the cash flow necessary to pay its bills or cover daily expenses/operations. In extreme cases, this can lead to bankruptcy or debt default, impacting stock prices.
• Foreign investment risk: It’s becoming increasingly common for investors to invest overseas, which opens them up to issues stemming from political turmoil, high inflation, and other forms of volatility (especially in underdeveloped countries).

Risk Management Strategies

When developing or updating your portfolio, you can use risk management techniques to balance risk and return.

The primary way to manage risk in your portfolio is to incorporate diversification. This is the principle of spreading your capital amongst different types of investments with varying levels of risk. This means incorporating investments across different asset types—stocks, bonds, and cash equivalents—and it goes even further to include investments across different locations (foreign and domestic), expected time horizons, issuers, tax treatments, etc.*

What Is Risk Tolerance?

Risk tolerance refers to an individual investor’s ability to accept risk from an emotional, psychological, and (to a lesser degree) financial standpoint. Essentially, what’s your comfort level when taking on risk? Your risk tolerance will reflect that.

If you have a high-risk tolerance, you’re comfortable with the possibility of a loss. If you’re risk averse, you may feel a stronger emotional reaction to losing money than to earning money, which may cause you to take fewer risks within your portfolio.

Your risk tolerance is typically influenced by a few common factors, including:

• How your family viewed money growing up
• Past experiences (such as a significant loss, lack of financial security, etc.)
• Your age
• Financial goals
• Personality

 
Why Understanding Your Risk Tolerance Is Important

Your risk tolerance is unique to you and can be subjective in some ways. Still, it’s essential to understand your unique tolerance levels—as they can help shape your long-term investment decisions. You can learn your risk tolerance by talking with an advisor and filling out risk-focused questionnaires. 

Your risk tolerance will then influence your asset allocation.

For example, the closer you get to retirement, the less risk-tolerant you become (generally speaking). This is because you’re getting closer to the point where you must rely on your investments to fund your lifestyle. If a significant market downturn happens the year you enter retirement, you want your portfolio to be protected from those potential losses.

On the other hand, when you’re still decades away from retirement, your risk tolerance may be higher—since your portfolio has plenty of time to recover from a potential downturn.

Integrating Risk Management and Tolerance in Investment Strategy

If you can’t stomach high risk, you must focus on low-risk investments. The downside is that low-risk investments generally come with lower returns, which may not be conducive to achieving your long-term financial goals.

Instead, you and your advisor should incorporate risk management strategies that balance your comfortability with risk and your long-term needs. In addition, it’s essential to monitor and periodically adjust your asset allocation to align with your evolving needs or changing market conditions—significantly since your risk tolerance will change as you experience new circumstances or move through different life phases.

Building a portfolio that reflects your unique needs

Understanding your relationship with risk is critical in building a portfolio that reflects your needs and goals. As you continue making adjustments, use your risk tolerance to shape your investment decisions over time.

Contact our team today to learn how we can help you build and maintain a well-balanced portfolio. 


*Asset allocation and diversification do not guarantee a profit or protect against loss in declining markets. They are methods used to help manage investment risk.

^{This is provided for informational purposes. The views expressed herein are those of the author and do not necessarily reflect the views of Steward Partners or its affiliates. All opinions are subject to change without notice. Neither the information provided, nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. All investing involves risk including possible loss of principal. Past performance is no guarantee of future results.}