How risky should the investments be in your portfolio? The answer to that question depends on whom you ask. If you asked Warren Buffett, he’d no doubt offer you his legendary comment: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.” If you asked a garden-variety commodities broker, he’d probably tell you “no risk, no reward.”
Maddening, isn’t it? You might as well compare a bicycle and a chauffeur-driven limousine as answers to the question “what’s the best way to get down town?”
The shades of gray between the Warren-Buffett and commodities-broker approaches comprise an entire industry of financial planners and advisers. How can you possibly know which approach is best? How much risk is advisable in an investment portfolio?
Fortunately, although definitive answers can be tricky to these questions, there are risk guidelines you can observe in your portfolio. Let’s consider some of them.
How Old Are You? – Age is a big – if not the biggest – factor in determining your level of portfolio risk. All things being equal, your age is the most important indicator of how much time you have left to recover from an investment that goes south on you. If you’re 85 years old, you’re probably best not investing heavily in momentum stocks, for instance.
How much risk is too much though? A classic metric is to subtract your age from 110 to determine an acceptable percentage of risk investments in your portfolio. In other words, if you’re 85, no more than 25% of your portfolio should be invested in stocks at all. According to the same formula, if you’re 35, you can afford to keep 75% of your portfolio in stocks. In both examples, the balance of the portfolios should be invested in bonds or investments with a surer return.
The important idea here is not the metric per se (some investment advisers recommend a metric of 100% instead of 110%). The very fact that you have a metric in place is more important than the specific percentage.
Do You Have a Separate Income In Place, Or Are You Living Off Income Generated By Your Portfolio? — Look at it this way. Would you risk this week’s paycheck on a particular stock? While it’s still your money even if you don’t depend on your portfolio to generate income, you clearly have less latitude for comeback if your portfolio income is what’s paying your bills. In adjusting that age metric we just mentioned (110%, vs 100%, say, or 95%), you need to consider whether you depend on your portfolio for income.
Will Your Portfolio At Its Current Rate of Return Be Sufficient To Fund Your Retirement For The Rest Of Your Life? If the answer to this question is no, and you’re still young enough and drawing a salary, you may want to consider factoring additional risk into your portfolio. Make sure though that any additional investment risks you take are prudent. Wild risk is a natural invitation to the poor house.
Do You Have Hard Assets in Place – Don’t console yourself that the financial crisis of 2008 is behind us. A portfolio weighted in paper can prove problematic. Hard assets like real estate, diamonds and precious metals are great hedges against a stock market bubble. Gold particularly is a useful counterbalance against the wavering value of the U.S. dollar.
Finally – if your tolerance for risk is minimal, it might be better for you to stick with index funds – an investment that won’t keep you up at nights. For many, the right level of risk is the one that offers them peace of mind.