There are multiple factors fundamental to picking an optimal investment strategy in a portfolio of mutual funds. The identification of an investor’s risk tolerance is one of them. No matter the portfolio’s time horizon or return objectives, risk tolerance will impact both asset allocation and selecting specific fund categories (such as an intermediate-term bond, short-term bond, international, small growth, large value, and so forth).
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Defining Risk
It’s wise to start with defining risk. Typically, the risk is about how the value of any given security might fluctuate.
These fluctuations are usually called volatility, and they can be anywhere from highly stable to quite erratic. Also, investment value can be impacted by a variety of kinds of particular risks.
For example, bonds might have these risks:
- Credit risk
- Principal risk
- Interest rate risk
- Inflation risk
Alternatively, stocks might feature:
- Currency risks (foreign stocks)
- Political risks (foreign stocks)
- Market risk (all stocks)
- Dividend risk (all stocks)
Proportionate Movement Both Ways
As the risk level goes up, volatility increases proportionately. However, so does the total potential for returns. Likewise, as the risk level decreases, total return potential and volatility decrease proportionately.
This is the standard rule of risk/reward. It’s often illustrated as both risk and reward escalating across a broad spectrum that starts with cash reserves before moving into bonds and then finally ending with equities.
Equity funds usually demonstrate both higher levels of risk and reward in contrast to bonds. However, equities and bonds both have their own spectrum of risk/reward.
From least to greatest risk/reward, equities and bonds each follow their own respective scales:
Equity Funds
- Large Value
- Large Growth
- Mid Value
- Mid Growth
- Small Value
- Small Growth
- International
- Emerging Markets
- Sector
Bond Funds
- Short-Term
- Government Mortgage
- Intermediate-Term
- Multisector
- Long-Term
- High-Yield
- International
- Emerging Markets
Risk Tolerance Categories
In the realm of mutual funds, investors typically have one of three different risk tolerances regarding the fluctuations in equity or bond fund value they are willing to put up with:
- Conservative Risk Tolerance: An investor willing to minimize volatility by accepting lower returns.
- Moderate/Average Risk Tolerance: This category investor looks for higher returns by accepting more volatility than a conservative investor.
- Aggressive Risk Tolerance: These investors accept huge swings in the volatility of prices so they can enjoy the biggest returns.
Contrasting Viewpoints
Applying risk tolerances to mutual fund strategies usually falls into one of two viewpoints. One of them just treats risk tolerance like a simple assect allocation adjustment, meaning in only involves a single risk/reward spectrum (equity, bond, or cash funds). Examples could include:
- Aggressive Growth: 100% stocks
- Growth: 80% stocks / 20% bonds
- Moderate Growth: 60% stocks / 40% bonds
- Conservative Growth: 40% stocks / 60% bonds
- Income: 20% stocks / 70% bonds / 10% cash
The alternative viewpoint considers risk tolerance in terms of fund category allocation after the basic asset allocation has been chosen.
In this perspective, the kinds of fund categories are chosen based on suitability to the decided risk tolerance. This approach enables a precisely customized investment strategy.
Picking the basic asset allocation prior to choosing fund categories is crucial. When coming up with a proper portfolio strategy of mutual funds, determining risk tolerance ought to be the final criteria that happen before selecting fund categories.
Picking fund categories before choosing the basic asset allocation will result in somewhat random fund selection. The strategy is not appropriate or effective.
Basic asset allocation should almost always follow this order or priority:
- Investment stage
- see our strategy guidelines for Just Starting investors (age 25-40)
- see our strategy guidelines for Established Earner investors (age 41-55)
- see our strategy guidelines for Soon-to-Retire investors (age 56-65)
- see our strategy guidelines for In Retirement investors (age 65+)
- see our guidelines for an Intermediate and Short-Term strategy
- Time horizon
- Return objectives
- Portfolio size
- Risk tolerance
In the fund category allocation methods, all three risk tolerances can mix well with various return objectives, so long as the time-horizon boundaries line up properly.
For instance, with a long-term time horizon, aggressive, moderate, and conservative risk tolerances can call work with income, balance, or growth strategies.
However, short- to intermediate-term objectives can also line up with income-focused objectives, although growth objectives do need long-term commitments.
A Hypothetical Scenario
Consider a hypothetical scenario using the method of fund category allocation. In this scenario, Smith and Jones both have relatively similar investment goals.
Both intend to retire a decade from now, and both want to reallocate $100,000 into a long-range, balance-focused plan that splits things equally between income and growth.
What differentiates them is that Jones prefers to use aggressive risk tolerance, but Smith is more of the conservative type. Under these circumstances, a basic allocation of half stock funds and half bond funds will apply to each of their portfolios.
Applying their respective risk tolerances could wind up with each having the following categories of funds and allocation percentages:
Jones
- 25% large-cap growth equity fund
- 15% mid-cap growth equity fund
- 10% small-cap growth equity fund
- 25% multisector bond fund
- 15% high-yield bond fund
- 10% international bond fund
Smith
- 30% large-cap value equity fund
- 15% mid-cap calue equity fund
- 5% small-cap value equity fund
- 20% short-term bond fund
- 15% intermediate-term bond fund
- 15% GNMA
With this hypothetical scenario, both portfolios reflect the particular investment preferences and objectives of Jones and Smith.
At the same time, they have drastically different allocations and fund categories. This happens even though risk tolerance is the only real difference in their investment characteristics.
Guidelines to Follow When Determining Risk Tolerance
Determining your risk tolerance is something you need to do, so use these guidelines when you do it:
- Respect Volatility: Take the possibility of downside loss as seriously as the potential upside you hope to gain.
- Figure Out Your Comfort Level: If you aren’t perfectly comfortable with a certain risk tolerance level, then pick a different one.
- Stick to Diversification: For that matter, stick to the fundamentals of proper diversification. Allocating your investment assets across a variety of fund categories and other asset classes helps you attain a number of specific risk/reward goals or criteria while also minimizing your broader portfolio risk.
- Do an Annual Reassessment: Your risk tolerance might change for different reasons. It could be major adjustments in your return objectives, but you also might just realize that your current risk tolerance isn’t right for your current circumstances.
When you mix risk tolerance with other investment objectives, you can use it to determine your best course of an investment strategy with a customized plan of mutual fund selections in category allocations suited to your needs.
Just remember, the first step is defining every single one of your preferences and objectives for a properly diversified allocation strategy that has clarity in its focus.