Your personal tolerance for investment risk should drive your asset allocation decision – A Tip from The Skilled Investor
Your tolerance for investment risk is a relative thing. Few people like investment risk, but some can handle it better than others do. The more investment risk you can and are willing to tolerate, the higher your potential expected investment returns and investment growth might be. At the same time, the investment road you will take might be rougher.
Also, the scientific finance literature has shown that securities markets tend to pay a return on investment only for shouldering investment risks at the market level — not at the level of individual securities holdings. (For more information see, these asset allocation and diversification articles on The Skilled Investor website: You must stay invested in the securities markets to earn market risk premiums and Investment securities markets do not pay you for the risks of holding individual common stocks and bonds.)
The primary cash, bond-fixed income, and stock-equity financial asset classes have different expected investment risk and return characteristics. Financial asset allocation is the apportionment of your investment portfolio into one or more of these classes of market-traded financial assets. How you allocate major portions of your assets among the primary financial asset classes determines your portfolio’s overall exposure to investment risk and thus your potential for investment growth. (For more information on these subjects, see The Skilled Investor’s articles in these categories: Returns and Risk Premiums (10 articles) and Securities Valuation (4 articles))
You may encounter numerous industry approaches to gauging you investment risk tolerance relative to other investors. Caution may be in order, if someone asks you only a few risk questions or presents you with a similar very short questionnaire. Using your verbal or written responses, you quickly may be labeled a “conservative” or “aggressive investor.” However, investment risk tolerance is a much more personally and emotionally complex subject.
Assessing your personal investment risk tolerance is one of the most important personal investment decisions that you will make, because this decision drives the long-term risk-return composition of your investment portfolio. This decision requires much more personal and family introspection than is provided by trivial risk questionnaires. These short questionnaires often are just a front-end to a securities sales process. After answering a few questions, you may soon be blessed with a canned percentage asset allocation to the cash, bond, [...]