Balancing Risk: Are You Taking On Too Much Risk? Or Not Enough?

Risk.

Many traders would say it's what defines their long-term success. Sure, if you're a professional trader, returns are your livelihood; but it's managing the risk that keeps you in the game.

Investors, too, would be wise to stay cognizant of the risks inherent in the market. Take on too much risk, and you could open yourself up to a drawdown that might wipe out several years of returns. But there's also such a thing as not taking enough risk. Low-risk investments such as passbook savings accounts or certificates of deposit, for example, might not outpace inflation over the long term, which means you're potentially eroding the value of your money over time.

In a perfect world, we could all achieve our investment objectives risk-free, but, alas, the investing world doesn't work that way. Risks are a part of any investment, so it's important to balance risk and return. 

Be Aware of Your Time Horizon

Have you ever felt the need to be aggressive in the stock market, like you need to hit objectives sooner rather than later? This could be a dangerous mentality for traders and investors alike. Saying to yourself, "I've got to make x amount of dollars this month or I won't hit my target" might force you into a trade or investment that doesn't fit your risk profile or objectives. Or it might force you to become impatient and liquidate a position that does fit your objectives, but may be underperforming in the short term.

The important thing is to match your level of risk tolerance to your time horizon. And different segments of your portfolio might have different levels of risk tolerance. This is especially true for active traders, who might manage the risk in a trading account differently than, say, a retirement account.

Do you find yourself in a mode where you buy and sell stocks or options for the short term, but never step back and look at those short-term plays in the context of your overall risk philosophy? Get a better understanding of your personal risk tolerance by considering whether your short-term and long-term objectives conform.

Consider a Third-Party Analysis

You might think you're conservative, but actually be more prone to some aggressive habits, or vice versa. Maybe you see excess risk as a determinant of your trading success, and thus bring too much risk into your long-term investments. Or maybe you do the opposite—maybe you think that, because you assume risk for a living, you set too low a risk tolerance for your long-term nest egg.

It might help to have a financial professional sort through your portfolio and ask some questions to get a better sense of whether it matches your long-term objectives.

For example, when Robert Siuty, senior financial consultant for TD Ameritrade, takes a look at investors’ portfolios, he keeps some key criteria in mind, including risk tolerance and the portfolio’s current exposure to risk. After putting an investor’s portfolio through a software tool that assesses how their investments might perform based on various market scenarios, Siuty talks with them about their risk profile and whether it’s appropriate.

“I simply ask the client where they fit on a risk scale of 1 to 10,” Siuty said. “Are you a 10/10, meaning very aggressive? Or a five? Or a one? Sometimes people come up with five, and it turns out they’re 100% in stocks. When we stress-test the portfolio and show them the downside risk, it’s often an epiphany for them and they realize they need to pull back the reins and re-think the portfolio.”

Getting a decent return can be an important objective, but adjusting for risk may be equally important for traders and investors alike.