A 60-Second Read by Anthony Benante, CFA: Though everyone’s financial situation, or what we call your personal economy, is different, developing the right investment strategy starts with identifying your risk profile. To do this you need to determine your willingness to take risk and your ability to take risk.
Your willingness to take risk is based on your personal feelings in reaction to the changes in investment values as markets move through different cycles. Most people have a general idea of how willing they are to accept risk and are familiar with terms like conservative, moderate or aggressive. If you are unsure, there are different questionnaires available to help you identify your willingness to take risk.
Your ability to take risk is based on what level of portfolio risk gives you the best chance to achieve financial success. In simple terms, what investment strategy helps make sure your money lasts longer than you. The only way we know how to do this is to build a comprehensive financial plan that includes your lifestyle needs and your resources (including your investment portfolio) to meet those needs. The plan should have the ability to calculate different scenarios, including the impacts of using different levels of risk with your investments. The risk profile of the investment strategy that gives you the best chance for achieving your financial goals determines your ability to take risk.
Note that your willingness to take risk may not match your ability to take risk.
Finally, once your risk profile is identified and your investment strategy is determined, more work is needed. They include, but are not limited to:
- Regularly reviewing the situations surrounding your personal economy
- Updating your lifestyle needs and resources
- Reviewing your investment strategy
- Rebalancing as needed
- Verifying investment choices
- Updating the plan’s probability of success
We call this having a feedback loop.
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