One of the most common things I hear in the financial world is how much the stock market fluctuates on any given day. “My portfolio is down today!” or “I wish I had invested earlier in Hot Stock Company before the market took off!” While I’m not a financial advisor, I’d like to offer some helpful suggestions for your investment portfolio from a CPA's perspective. Whether you’re new to investing or a seasoned pro, I hope this article provides some value. Or at the very least, gives you something to consider.
Understanding Risk
When building your portfolio and deciding where to invest your hard-earned cash, there are two important aspects to consider: risk tolerance and risk capacity.
Risk Tolerance
Risk tolerance is subjective measure assessing your comfort level with your investments. Essentially, it boils down to how much loss can you handle and still sleep at night? Your risk tolerance plays a critical role in determining your asset allocation (i.e., how much of your portfolio is invested in stocks versus bonds).
To get a sense of your risk tolerance, I recommend taking one (or both) of these free risk tolerance questionnaires:
- Vanguard Investor Questionnaire: (https://investor.vanguard.com/tools-calculators/investor-questionnaire)
- Schwab Investment Questionnaire: (https://www.schwab.com/resource/investment-questionnaire)
At the end of the questionnaire, you’ll receive a result that ranges from conservative to aggressive, reflecting your investment strategy and a guide to your asset allocation. There’s no right or wrong answer here. This questionnaire is entirely personal and depends on your appetite for investment risk.
Risk Capacity
Equally important to consider is your risk capacity, an objective measure complimenting your risk tolerance. Risk capacity factors in elements like your income, assets, liabilities, dependents, insurance, and investment timeline. It reflects how much financial risk you can afford to take without jeopardizing your financial goals.
One simple formula you can use to gauge your risk capacity is:
Net Worth / Investable Assets (i.e. how much you want to invest)
To calculate your net worth:
1. Add up your assets.
2. Subtract your liabilities.
3. Add your net future cash flows (net income after expenses).
Let's take a look at some examples
To better understand how risk capacity works, let’s look at two hypothetical investors: Mason and Aidan. Both are deciding how to allocate their investments, but they are in very different financial situations.
Mason’s Scenario:
Mason has $10,000 he wants to invest. Before deciding how to allocate his funds between stocks, bonds, or other assets, he needs to evaluate his financial standing. Here's how he breaks it down:
- Assets: Mason has $50,000 in assets, which could include things like savings, property, or retirement accounts.
- Liabilities: He also owes $25,000 in liabilities, such as student loans, a car loan, or credit card debt.
- Net Income: After covering all his necessary living expenses for the year (rent, groceries, utilities, etc.), Mason is left with a net income of $10,000.
To calculate net income, Mason first looks at his total annual take-home pay after taxes. Let’s say his after-tax income is $50,000. He subtracts his living expenses for the year, which include costs for housing, food, utilities, and anything spent on dependents, insurance, or other essentials. After deducting all of these, he finds that he has $10,000 remaining, which represents his net income, the amount left over after all necessary expenses are paid.
Using this information, we can calculate Mason’s net worth and risk capacity:
- Net Worth: Mason's net worth is calculated as $50,000 (assets) - $25,000 (liabilities) + $10,000 (net income) = $35,000.
- Risk Capacity: To find his risk capacity, we divide his net worth by the amount he wishes to invest: $35,000 / $10,000 = 3.5.
Since Mason’s risk capacity is 3.5, this means he can afford to take on more risk in his portfolio. If the market takes a downturn and he loses part of his investment, his overall financial stability isn’t at significant risk because part of his net worth can cover the loss. Mason could also consider a more aggressive investment strategy, knowing that he has a financial cushion.
Aidan’s Scenario:
Now let’s consider Aidan, who is in a different financial position but also wants to invest $10,000. Here’s his situation:
- Assets: Aidan has no assets—he hasn’t accumulated savings, property, or retirement funds yet.
- Liabilities: He owes $25,000 in liabilities, such as student loans or credit card debt.
- Net Income: After paying all of his living expenses for the year, Aidan is left with $10,000 in net income, just like Mason.
Now, let’s calculate Aidan’s net worth and risk capacity:
- Net Worth: Aidan's net worth is calculated as $0 (assets) - $25,000 (liabilities) + $10,000 (net income) = -$15,000.
- Risk Capacity: Aidan’s risk capacity is calculated by dividing his net worth by the amount he wishes to invest: -$15,000 / $10,000 = -1.5.
Aidan’s risk capacity is -1.5, which is a red flag. A negative or below 1 risk capacity means Aidan is not in a financial position to take on much, if any, investment risk. If he were to lose the $10,000 he’s planning to invest, he would be in a precarious financial situation, possibly unable to cover debts or living expenses. Aidan’s best course of action would be to adopt a conservative investment strategy, focusing on preserving his capital rather than seeking high-risk, high-reward investments.
When Risk Tolerance and Capacity Don’t Match
A common challenge for investors is when their risk tolerance and risk capacity don’t align. For instance, let’s say Aidan takes the risk tolerance quiz and finds out he has an “aggressive” risk tolerance. He feels comfortable taking on more risk, but his financial situation (as measured by his risk capacity) suggests he should be more conservative. If Aidan invests aggressively and the market takes a downturn, he could lose all $10,000 and find himself in a precarious position. It’s absolutely crucial to strike a balance between how much risk you’re comfortable taking and what is reality, how much risk you can afford based on your financial circumstances.
My Two Cents: Whether you're new to investing or a seasoned professional, always consider both your risk tolerance and risk capacity when crafting your investment strategy. These two metrics can also inform your approach to business investments. Ultimately, the decision about which investments to pursue is yours, but my goal is to equip you with more knowledge and insight to help you make informed choices.
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