When we put together an investment model, the primary factor we consider is risk. The amount of potential investment decline one can withstand will determine the mix of investments we use to build the diversified portfolio. When we build a financial plan, we match the risk of the portfolio to the goal it is intended to achieve and, typically, the further out the goal is the more risk you can accept.
However, we have recently faced the question, “how aggressive should I be when I don’t have a specific goal in mind for my money?” In most cases, this question comes up when a client already has financial resources designated for all of their primary goals and simply has additional funds available to invest. Often this is money they may never need in the future. As with many similar questions, the answer will depend on your specific situation and risk tolerance.
For some clients, the answer is to take little-to-no risk. Essentially, they are saying, “If I don’t need to take risk with the money, why would I?”. This would generally be how someone with a more conservative inclination would respond and would view this as an opportunity to avoid additional risk that could otherwise may make them nervous.
For other clients, the answer is to take significant risk with that money. They would say, “If I don’t need the money, I can afford to risk more!”. This person is comfortable with a higher level of risk and therefore, sees this as an opportunity to generate more return without having to worry about it negatively affecting their future if does work out as expected.
Both of these responses are perfectly acceptable in the context of a goals-based financial plan. Knowing where you place more value (safety vs. opportunity in this case) is a necessary starting point for understanding your personal risk tolerance. Understanding your personal risk profile is an important step for knowing when to take appropriate risk and knowing when to avoid certain risks.
Where do you need to recalibrate your risk tolerance for a particular goal?