Building your wealth is a constant balancing act between adopting new growth opportunities and hedging your portfolio against risk. You want to get the best possible ROI, but not at the risk of losing a substantial portion of your principal investment. Thus, a practical risk evaluation is one of the best ways to manage your portfolio safely and efficiently.
Financial advisors use many different names to refer to a risk evaluation — risk analysis, risk assessment, cost-benefit analysis, and so on — but they all refer to the same basic process. So, what is the purpose of a risk assessment? Why are risk assessments important? What risk assessment methodology is best for you? Finally, how can a qualified financial advisor help you with your next portfolio risk management analysis?
We will answer all of these questions and more, but first, it is important to know when a risk evaluation is right for you.
Every portfolio needs some type of risk evaluation on a regular basis. Whether you choose to evaluate your risk capacity annually, bi-annually, or once every five to ten years, you need to have a schedule in place. This way, you are less likely to miss potential issues that could cost you over the long term.
You should also consider getting risk evaluations before, during, and after major life transitions. If you are getting married, divorced, changing jobs, moving, retiring, or making an equally significant life change, you need to see where your portfolio risk stands. Major changes could greatly affect your ability to take on more or less risk in the future.
For example, if you are going through a divorce, you may have to split your accumulated assets with your ex-partner or even give up possessions of high-value like real property. With fewer funds and less security in your finances, you will want to recalibrate your portfolio. If (at the time of your divorce) you are invested in high-risk, high-return assets, you may want to move a portion of your wealth over to low-risk investment vehicles. In any case, a risk evaluation can help you find the best course of action for your portfolio and personal circumstances.
It is important to differentiate between risk tolerance and risk capacity, as people often confuse the two terms. Risk tolerance refers to the amount of risk you are comfortable taking on. Alternatively, risk capacity refers to the risk that you need to take on to meet your financial goals.
There is no magic formula for understanding your risk tolerance. That said, some important indicators to help you conduct your own risk analysis include:
- Age – Generally, the younger you are (and the farther you are from retirement), the more risk you can take on.
- Income – One of the most important factors is your current income and your expected income over the next few years. The higher your earnings, the more risk you can take on in your portfolio.
- Marital and Family Status – While marriage often provides greater financial stability, it also means that you have to consider the risk tolerance of your entire family. Children often reduce your ability to take on high-risk investments due to increased long-term costs, like healthcare and college savings.
- Asset Classes – The types of holdings and assets in your portfolio will also help you determine your own risk tolerance. For example, if most of your funds are tied up in non-liquid assets like art or collectibles, you will likely need to take on less risk. On the other hand, if your portfolio is primarily comprised of liquid assets like stocks or mutual funds, you can probably take on more risk.
Fortunately, risk capacity is a bit more quantitative. This is why a practical and comprehensive risk evaluation is so important. If you want to get a clear picture of your risk capacity, you need a qualified financial advisor to look over your finances and discuss what you want to achieve with your wealth. They will then evaluate your current and future investment cash flows, the total value of your investments, as well as the timeline needed to reach your goals.
There are many different types of risk assessment methodologies that can help you determine the best investment decisions for you. However, at Merit, our risk assessment methods focus on wealth enhancement and protection. We take into account your entire financial picture, from cash flow and debt management to insurance benefits and pension plans. By trusting your portfolio with Merit, you can gain invaluable insights and potential improvements to your investment plan. Moreover, we offer continual portfolio risk management to manage and preserve your wealth for years to come.
Are you in need of a risk evaluation? Do you need help determining your own portfolio risk, risk tolerance, and risk capacity? For a more practical risk assessment, be sure to contact Merit Financial Advisors today!
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.
Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Merit Financial Group, LLC, an SEC-registered investment adviser. Merit Financial Group, LLC and Merit Financial Advisors are separate entities from LPL Financial.