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How much investment risk can you really take on?
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Knowing your risk capacity — not just your risk tolerance — can help you create a portfolio that keeps you on track toward your goals even as financial markets change.
Key Points:
  • While risk tolerance helps you understand your willingness to take risk, risk capacity tells you how much financial risk you can afford to take at a particular point in time.
  • Understanding your risk capacity can help you make more strategic investing decisions.
  • Common factors for assessing your risk capacity include: your need for cash/liquidity, your investing time frame and the importance of an investment portfolio to your financial well-being.
All investing involves risk as you seek potential gain. But just how much risk are you prepared to take on as you strive to meet important life goals, such as a comfortable retirement or saving for college?
You’ve probably seen tools that help you determine your risk tolerance—your willingness to take risks when you invest. Based on your answers about the investments you prefer and your feelings about the risk of loss, the results usually suggest an asset allocation that falls somewhere on a risk spectrum, shown below, from conservative (risk averse) to aggressive (willing to take on substantial investment risk).
Risk tolerance by asset allocation and investment mix
Typically, the more aggressive an investor’s risk profile, the higher the percentage allocated to stocks and riskier fixed income investments such as high-yield bonds. While these riskier investments expose the investor to greater potential loss, they also have the potential to deliver higher returns than more conservative, lower-risk investments such as high-quality corporate bonds, treasuries and CDs.
Risk capacity: How much potential financial loss can you afford if the market drops?
Knowing where you fall on a risk spectrum can help you understand yourrisk tolerance. But it won’t help you understand your financialrisk capacity, which gauges whether your portfolio can withstand a significant market downturn without jeopardizing your goals. "Instead of considering how you feel about risk and how willing you are to take it, think about whether you can financially afford to take a risk with your investments at a particular point in time," says Michael Liersch, managing director, head of behavioral finance and goals-based consulting for Merrill Lynch.
Instead of considering how you feel about risk ... think about whether you can financially afford to take a risk ...
For example, let’s say you’re a young investor who tends to have a low risk tolerance (on the conservative end of the risk spectrum) and you’re saving for retirement, which is more than three decades away. Because you have many years to absorb the fluctuations of the stock market, you may be able to afford to be more aggressive, allocating a larger portion of your retirement portfolio to riskier investments that have the potential to deliver higher returns.
So even though you may feel just as conservative about risking your investments as a person who is closer to retirement, you may actually have a higher risk capacity for your portfolio than someone who is older, needs the money sooner and doesn’t have time to ride out market volatility. Of course your actual risk capacity will depend on your financial circumstances and the specific goals you have for your investments.
Factors that affect how much risk you can take
Risk capacity provides another dimension for assessing how much risk you can take on as you build and manage investment portfolios for each of your goals. "Many investors consider themselves conservative, moderate or aggressive. However, the risk level that is truly right for an investor may depend on a variety of factors that go beyond his or her willingness to take risk," explains Liersch. Those factors can include, but are not limited to:
  • Your time frame
  • The importance of the goal to your financial well-being
  • Your liquidity or cash needs, now and in the future
The table below shows a few of the reasons your risk capacity may change over time.1
The 3 key factors that affect investment risk capacity
In general:
  • The lower your risk capacity, the more conservative your investments may need to be, because you can’t afford to lose as much money or because your deadline for using those assets is approaching soon.
  • The higher your risk capacity, the more you may be able to afford to include riskier investments, such as stocks and high-yield bonds, in your portfolio while still being prepared to weather a market downturn without seriously jeopardizing your goal. .
"But even if your risk capacity suggests that you can expose your portfolio to significant stock holdings, if you can’t sleep at night, that’s not a good outcome and you may want to reevaluate your investment choices," cautions Liersch.
What is your personal risk capacity?
While there is no magic formula for calculating it, Liersch recommends asking yourself a few key questions to assess your current capacity for risk as part of your regular investment review.
What are my liquidity needs? Do I have enough cash to meet my minimum expenses and obligations?
Is the goal I have for this investment essential to my overall financial well-being now or in the future?
Do I have the time to ride out any short-term losses to achieve longer-term gains?
You can reevaluate your risk capacity as your cash needs and/or time horizons shift for any of your goals. If nothing has changed, professionals at Merrill Lynch®still recommend that you review the asset allocation, investments and risk capacity for each of your goals at least once a year.
Ultimately, risk is a multidimensional concept that should be considered in terms of the goals you are trying to accomplish — and how comfortable you are with the investments you’ve chosen to try to meet those goals, says Liersch."By considering risk capacity, an investor can challenge his or her perspective when making investment-related decisions."
How Merrill Edge® can help
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1Adapted fromBehavioral Insights: Risk Tolerance and Decision-Making, Michael J. Liersch, PhD, and Riley O. Etheridge, CFA®, CFP® Investments & Wealth Monitor (March/April 2015) p. 19. http://www.imca.org

Diversification and asset allocation do not ensure a profit or protect against loss in declining markets.

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