Creating a financial plan helps you discover and establish your financial goals, and then develop a plan to help you achieve those goals. In the previous articles we covered the importance of setting up a plan, how it can maximize your retirement and social security benefits, and the different goals and topics your plan should cover. You click here for more information.
Your financial plan will also help you manage your risk. Many people overlook this step and do not have a plan that adequately reflects their risk tolerance. Your goal is to choose investments that are suitable to your risk tolerance and get the most return for the amount of risk you are willing to take.
Risk is measured by your financial ability to withstand losses. Investments have different levels of risk and potential return. The more you risk you take, the greater the reward should be, and vice versa. While many equate risk to just finances, there is a large emotional component of risk tolerance. Emotions can be more powerful than logic and drive investors to make decisions without regard to their finances.
Why is understanding both your financial and emotional risk so important? If you take too little risk when you are younger, you may be leaving a lot of money on the table by not taking advantage of time’s effect on compound interest. If you take too much risk during your later years in life, you may not be able to recover the losses in time. This unfortunately happened to many people who were close to retirement during the 2008 crisis.
Your risk is determined usually by your time horizon, financial resources, demographics, experiences, and personality. There are generally three different types of people when reacting to risk.
- Risk Seeking – Risk tolerant individuals and prefer uncertainty over certainty
- Risk Aversion – Risk rejecters and prefer certainty over uncertainty
- Risk Indifference – In the middle, willingness to make an investment based on it expected return without regard to its risk
How do you find your risk tolerance level? The most common techniques are through a risk tolerance questionnaire, examining your investment objectives, your preferences for various investment products, attitudes towards risk, and real-life choices involving risks. Visit artofthinkingsmart.com/go/plan to take a risk tolerance questionnaire and test.
Once you know the level of risk you are willing to take, then you are able to pick the right type of investments and your asset allocation. Unfortunately many people adapt their risk tolerance to investment products rather than have the correct mix of investment products to fit their risk tolerance.
Generally, investors who focus on the performance of their investments without regard to their risk tolerance will experience a roller coaster of emotions and potentially miss their goals. As a result, their confidence is tied to the stock market.
But those with a financial plan that stay focused on their strategy will only need to have confidence in their strategy. A good financial plan with your optimal investment portfolio adjusted with your risk tolerance will help you be more secure in your confidence!