Risk is a central issue in the financial planning world. When financial advisors speak with clients, they often discuss how risk relates to potential payoffs. Likewise, they'll discuss whether a client has an appetite for risk. It is important to know how to think about risk, so let's look at how it fits into financial plans.
Risk Premiums
Generally speaking, higher-risk investments tend to have higher rewards if they pay off. Consider fixing up a house so you can sell it. There are numerous risks associated with buying and fixing the house, including shifts in the market and undiscovered problems with the building. Consequently, someone buying a house for the purpose of flipping it will want a risk premium when they buy it. This means the price of the house should be lower to make up for the inherent risks they're taking on.
The same logic applies to many types of assets. If someone buys the stock of an early-stage pharmaceutical company, they usually expect the price to be quite cheap. Conversely, an established pharma giant that's making tens of billions of dollars per year is going to have a stock price that's expensive.
Need for Risk
In financial planning, growth is the goal. When higher-risk investments pay off, the returns can turbocharge portfolio growth. For this reason, financial advisors will encourage most clients to have some risk in their portfolios.
Notably, the greater your wealth is, the less need you have for risk. A portfolio filled with bonds can create good and steady returns if the owner has millions of dollars invested, even if the bonds only return something like 4% a year. For someone starting out with $10,000, however, that rate of return isn't going to get the job done. Especially if they're over 40 and need to make up some ground before retirement, they may need to take on more risk to seek greater potential returns.
Constant Reassessment
It is also important to regularly reassess your risk profile. If an investment paid huge returns, for example, you might think about cashing out part or all of it to take that risk off the table.
Similarly, a successful investment can grow so large that it can become a source of risk. If 60 percent of your portfolio is tied up in a single asset, the risk is huge if that asset drops in value. A person might sell enough of their stake to get that down to a more reasonable level, such as 10 percent.
Reach out to a financial planning service to find out more.
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