Setting your financial goals is a key step in taking control of your wealth. By determining what you’re trying to accomplish and assigning each of your financial accounts to the appropriate goal, you can ensure that your investments are aligned with your objectives.
What should you be thinking about when deciding which accounts should be part of each goal? All accounts in any one goal should have a similar time horizon (meaning when you’ll need the money) and should be similar in terms of how much risk you’re willing to take. For example, you might combine an IRA account with a 401k account (and possibly other accounts as well) into a “retirement” goal.
Combining accounts into these kinds of groups rather than managing each one individually lets you more efficiently manage your investments. It can also help you recognize and avoid risks that can build up across multiple accounts in your portfolio. And compared to lumping all of your accounts together into one giant pile, splitting them into goals can help ensure that you’re on track to meet each of your objectives. By combining similar accounts into the same goal, you can get a clearer picture of your financial situation and make better investing decisions.
We recently discussed the importance of sticking to a set risk level. But what should that risk level be? Since more risk can result in larger potential gains but also larger potential losses, correctly answering this question is one of the most important parts of successfully managing your wealth.
There are two key factors that should determine your risk level. The first is how much risk you are able to take. The second is how much risk you are comfortable taking. While these two ideas sound similar, they can often be very different.
How much risk you are able to take depends the details of your financial goal. You can take a lot more risk if you don’t need the money for 40 years than if you need the money in the next few years. You can take a lot more risk if the amount of money you need for your goal is somewhat flexible rather than a fixed amount. And you can take a lot more risk if your goal is something that would be “nice to have” (like a nice yacht) rather than something you consider absolutely necessary (perhaps a child’s education).
How much risk you are comfortable taking depends on how you react to the ups and downs of financial markets. If you can handle sizable drops in your wealth without losing sleep, you can take on more risk than if every market dip caused you to panic.
So when these two factors don’t align, which one should determine your risk level? The answer is whichever one suggests a lower amount of risk. If you’re not comfortable taking much risk for one of your goals, for example, it doesn’t really matter how much risk you’re potentially able to take: you shouldn’t lose sleep over your investments just because you “can”. Conversely even if you’re comfortable with a high amount of risk, if you need the money in the near future your risk level should probably be fairly low.
When the stock market is rising—as it has been for much of the past 5 years—it’s common to think that you should be taking more risk with your investments. When the stock market goes down, it’s common to think the opposite. But constantly shifting around the amount of risk you’re taking in response to how financial markets are doing is a recipe for poor long term performance. A better idea is to take a longer-term view of the risk you want for your portfolio and stick to that risk level.
There are two main problems with constantly shifting around how much risk you’re taking. One is that it’s very difficult to do successfully. It’s natural after markets have rallied to regret not having taken more risk. But the better time to take more risk would have been before the market went up, not after. Increasing the risk of your portfolio after markets have gone up simply puts you in a position for larger losses when the markets reverse course.
A second problem with shifting your portfolio’s risk in response to what markets are doing is that your portfolio can easily become disconnected from your real-world financial goals. If you’re investing money that you plan to use in the near future, it may be a good idea to take less risk to ensure that your portfolio won’t lose a large amount of its value shortly before you need the money. Remembering this may be more difficult when you’re constantly shifting around your portfolio’s risk level. If your financial goal has a short time horizon and you happen to take on more risk right before markets decline, you put yourself in danger of not being able to reach your goal.