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How much risk should I take with my investments?
We find this question is one of the most common we hear from our clients, and also one of the most important. So, how do you know if your portfolio is structured properly? There has to be something more than an advisor just telling you everything is ok. There has to be a more scientific and objective way to evaluate your portfolio. Because this is so critical to our clients’ success, we have made it a priority in our practice.
As advisors, we can do many things. We can help identify goals and prepare financial plans to accomplish those goals. We can create and maintain diversified investment portfolios. But we CAN’T change your risk profile.
What do we mean? Few people have a problem with risk when the market is rising. It’s when our portfolios are moving in the opposite direction that we become uncomfortable. So, when we talk about risk, we really mean “How much short-term volatility are you willing to accept in order to realize the long-term gains you are hoping for?” This risk/return tradeoff is unique to you and understanding your expectations is critical if we want to serve you well.
What is my Risk Number?
The Risk Number is a proprietary scaled index developed by Riskalyze to reflect a “risk score” for your unique Risk Fingerprint, or for a specific portfolio of investments. As you can see, it’s shaped like a speed limit sign, so a higher Risk Number means a higher level of risk and potential return.
Your unique Risk Fingerprint is a multi-dimensional variable reflecting the complexity of your specific risk tolerance. On the other hand, the Risk Number is a single-dimension variable designed to approximate the relative risk between people or portfolios. Thus, a “45” portfolio generally has more risk than a “44,” but two “45” portfolios may be quite different from each other.
The Risk Number is the first step, but the real challenge is in turning your multi-dimensional Risk Fingerprint into a comfort zone… a certain amount of downside risk you are comfortable taking over a six month timeframe, in exchange for the opportunity to achieve a certain amount of return.
One of the most important drivers of the Risk Number is the measurement of downside risk: either the downside risk in your comfort zone (the range of risk to reward that they are comfortable with) or the downside risk in a portfolio as measured by the 95% probability range.
Every time we design a portfolio for a client, Riskalyze calculates a range (e.g. –7% to +12%) that constitutes a 95% probability for that portfolio’s outcome, six months from then. A portfolio with a range that matches the client’s comfort zone therefore has a 95% probability of staying within the client’s risk tolerance.
If we know the temperature is 15 degrees outside and we wear shorts and a t-shirt, we have failed to use some valuable information effectively and the consequences aren’t pleasant. It’s exactly the same with your risk number. Knowing it is great but is also pointless if you don’t use it effectively. Here’s a summary of how we use this valuable information to help our clients maximize their satisfaction with their investment portfolio.
How much risk are you taking today?
Most people don’t know exactly how much risk is in their existing portfolio. We can review your current investment lineup, calculate its risk number and compare it to your personal risk number. Often, we find a significant difference between the amount you are willing to risk and the amount of risk you are actually taking.
Align your portfolio with your risk number
Armed with these two numbers we can easily provide some action steps to bring your portfolio into alignment with your risk profile. Once we know the amount you are willing to risk we can provide you with a reasonable estimate of the gains you might expect in your portfolio over time. In other words, we can help you design an investment portfolio with a range of potential gains and losses over time that is within your comfort zone.
We can evaluate and illustrate how well your current and our proposed portfolios are hedged against interest rate swings, market collapses other historical market events.
Risk & Reward Potential
The Risk/Reward Heatmap quickly shows us the relative risk and reward that each individual investment is adding to the portfolio.
It allows us to see a visual representation of the potential risk (red bar), potential return (green bar) and the amount of risk that is diversified out by inverse correlations (gold bar) for each investment in the portfolio. It also allows us to understand the potential risk and return that each investment is contributing to the total portfolio. This allows us to make better decisions about the best way to combine these investments to best reach your goals. It also gives us a personalized return benchmark against which we can measure your actual returns going forward.