Have you ever really tried to determine what your real risk tolerance is when it comes to investing? Most people by nature will tell you that they are not afraid of risk. They will tell you that they don’t mind that things will go up and down in value. That is, of course, until those investments actually start going down. It’s only when the monthly statements are down, your real estate is down, or some private equity deal is going down the tank that you can really determine your threshold for risk. With all of the uncertainty with the economy today, maybe it’s time to determine again just how risky are you?
The amount of risk you take with your investments should be directly proportional to how much time you have to let the investments sit and work for you. We have always used the analogy of a swimming pool to discuss risk with clients. Most community or neighborhood swimming pools have a baby pool and a main pool swimming area. The baby pool is typically only 6 inches to a foot deep. The main swimming pool usually starts out with an area that is 1 to 3 feet deep, moves to the middle part that slopes down from 4 to 7 feet deep, and then the deep end, which is typically 7 to 10 feet deep. If each foot represented one year of time that your money was to be invested, you could translate how many years you need to stay in a particular investment to warrant the risk you will take with the investment.
Here’s how it works. If you have 6 months to 1 year for a financial goal, you really can’t take that much risk and probably belong in the baby pool. These may be investments such as savings accounts, money market account, or short term CD’s. If you have 1 to 3 years to a financial objective, you can take a little bit more risk and use things like longer term CD’s, short-term bonds, etc. As you move through the pool, if your goal is 4 to 7 years away, this may be the first time you can consider intermediate type bonds or the stock market if you have more than five years. Last, if you have 7 to 10 years to a goal you can begin to look at more aggressive investments such as emerging markets, technology, or longer-term real estate investments. The big mistake most people make is to choose investments that are not suitable for their particular time frame to a financial goal. This is why people who invest in the stock market for a goal only one year away can be taking on abnormally high and undue risk.