We recently discussed the importance of sticking to a set risk level. But what should that risk level be? Since more risk can result in larger potential gains but also larger potential losses, correctly answering this question is one of the most important parts of successfully managing your wealth.
There are two key factors that should determine your risk level. The first is how much risk you are able to take. The second is how much risk you are comfortable taking. While these two ideas sound similar, they can often be very different.
How much risk you are able to take depends the details of your financial goal. You can take a lot more risk if you don’t need the money for 40 years than if you need the money in the next few years. You can take a lot more risk if the amount of money you need for your goal is somewhat flexible rather than a fixed amount. And you can take a lot more risk if your goal is something that would be “nice to have” (like a nice yacht) rather than something you consider absolutely necessary (perhaps a child's education).
How much risk you are comfortable taking depends on how you react to the ups and downs of financial markets. If you can handle sizable drops in your wealth without losing sleep, you can take on more risk than if every market dip caused you to panic.
So when these two factors don’t align, which one should determine your risk level? The answer is whichever one suggests a lower amount of risk. If you’re not comfortable taking much risk for one of your goals, for example, it doesn’t really matter how much risk you’re potentially able to take: you shouldn’t lose sleep over your investments just because you “can”. Conversely even if you’re comfortable with a high amount of risk, if you need the money in the near future your risk level should probably be fairly low.