Risk means different things to different people. Risk is defined as “exposure to the chance of injury or loss; a hazard or dangerous chance; the degree of probability of a loss.” When it comes to investment portfolios, most people think of risk as the possibility of losing money.
The media often focuses negatively on short-term market fluctuations which can make investors risk averse. Fund managers are managing a product so they generally focus on risk parameters such as volatility and the maximum loss for the product over a certain time period. Their focus is not on the specific needs of individual investors who are buying that product.
So how much risk do you need to take with your investment portfolio? Let’s use retirement as an example. If you think you need $60,000 per year if you retired today but you have 25 years until retirement, you may actually need about $85,000 per year to maintain the same standard of living, assuming an annual inflation rate of 1.5%. That means you need to have accumulated about $1.5 million of capital to cover your needs over 30 years of retirement. The real risk for most people is not having enough money.
Here are seven steps to managing risk in your investment portfolio.
- Start with a goal. Whether you’re buying your first house, saving for your children’s education or planning for retirement, a sound investment plan starts with a specific goal.
- Create a financial plan to meet that goal. If you need help, a financial professional who is committed to your best interests can create a financial plan based on the level of risk you are comfortable with to help you achieve your goal.
- Pay yourself first. Determine how much you can invest, ideally from each paycheque – it is important to start early. If you set up an automatic withdrawal from your account, you soon won’t miss the money.
- Ignore short-term market fluctuations. The markets can move sharply from time to time, causing worry for some investors. So think long-term, taking into account the time horizon for reaching your goal. Investing in your future is a marathon not a sprint!
- Be realistic about your return expectations. A reasonable number to work with is 7 per cent to 8 per cent return in the long term. If you start saving early and regularly, you may be able to reach your goals without having to take undue risk aiming for very high rates of return.
- Take only as much risk as you need. For example, if you already have $200,000, are committed to saving regularly and think that $1.5 million is sufficient for your retirement you may not need a return of 8 percent over the next 25 years, and can maintain lower risk in your investment portfolio.
- Focus on what you can control. You have control over how much you are saving, your lifestyle expectations today and in retirement, and your costs of investing. You do not have control over the markets, rates of return, or the rate of inflation. So don’t let it keep you up at night.
Remember, risk is not a bad thing – it just needs to be reasonable, within the context of your needs and managed well, especially as you get closer to your goal. Think of risk as the consequence of not reaching your goal – the longer you wait, the more this risk will increase over time.
Saving regularly in accordance with your plan and reducing your investment costs are the two things that can almost certainly bring you success in reaching your goals. Taking the time to put together an investment plan is the first step.
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