Polonius to Laertes, his son, in Act 1, Scene III, of Hamlet: “This above all: to thine own self be true.” William Shakespeare
According to the website Literary Devices, Polonius, addressing his son, believed that “a person can be harmless and good to others when he is financially sound. Therefore, he must be loyal to his best interests first, then take care of others.”[i] Today the above quote from Hamlet is typically used to underscore the virtues of honesty and commitment, however, even then it was a virtue to be financially sound.
How well do you know yourself? Just as for Laertes, it is one of the most important questions to answer to build a sound financial future. Can you honestly say how careful you are with your money? Does it fly out of your wallet or do you hold on tight? Are you willing to spend money on others but neglect to save for yourself and your future? Maybe your philosophy is to live life to its fullest and worry about the future later. Or perhaps you are a worrier and are very frugal with your money.
Clues from Your Past and the Present
Many things affect your relationship to money. A major one is your experience with money growing up. Did your family scrimp to cover life’s essentials? In one of my previous blogs, Financial Fears, I shared that my father kept track of every penny coming in and going out of our household. My parents were willing to forego other purchases to reach their financial goals—college for all children and no debt. They did not take many risks with their money but, along with those goals, they contributed to causes they loved, visited family and friends, and lived comfortably. That certainly impressed me and taught me the value of saving. How do you think your early experience affected your money patterns?
Your own experiences also play a role in how you feel about money. If you lost your job and had to declare bankruptcy, or recently divorced or became a widow or widower, you may feel anxious and afraid for your financial future. Maybe COVID caused a financial strain on your household. On the other side of the financial spectrum, a promotion with a nice raise or a windfall from an inheritance or a gain from a house sale may leave you feeling financially comfortable and relaxed. Your financial world is sunny.
Is Investing Right for You?
Investing in stocks and bonds involves a certain level of risk. Unlike saving, which I’ll define as putting money in interest bearing accounts like money market accounts or certificates of deposit that do not risk principal, investing carries the risk of loss of principal. (A future blog will discuss the difference between saving and investing in more depth.) Because of the risk of loss, investing is not a good fit for everyone. Is it right for you? That depends on many factors: can you meet your living expenses, have you established an ample emergency fund (see my blog: The First Financial Step), do you have debt under control, and have you prioritized your goals? Let’s say you can answer “yes” to all those questions. If you have additional funds that you can put away for long-term goals, then you might want to consider investing. Many of you will get your first taste of investing through your company’s retirement savings plan and I encourage you to take advantage of it as long as you have the needs mentioned above covered. Especially if your company matches part of what you put away, you win!
There are so many choices when you start to invest. It can be confusing. Before you make any choices, however, you must know yourself. Do you like to take risks? How much risk is too much for you and, conversely, how much is not enough? When it comes to investing, various resources can help you determine your risk profile or risk tolerance. It is the most important investment question to answer. Why? The right amount of risk will keep you invested and that increases the likelihood that you will reach your investment goals. If you take on too much risk (lots of stock), your return might be greater, but you may get scared and panic and sell when the market is down. On the other hand, if you are too conservative (not enough stock), you may have to work longer or change your lifestyle to offset the lower return, or even give up some of your goals entirely. Risk and return are related.
Do you remember the stock market downturns of 1987, 1999-2000, or 2008? The drop in 2020 is fresh in all our minds! If you were invested through any of those periods, what did you do? Did you panic and sell? Did you use the drop as a buying opportunity? Did you stay the course and do nothing? If you sold, it is likely that you were invested too aggressively (too much stock), and you probably sold at a loss. If you had extra funds to buy more stock as the market dropped, good for you! If you stayed the course, you discovered that the stock market eventually recovered, and moved higher. You are almost certainly ahead of anyone who sold, and that is the goal of assessing risk—keep you from panic selling!
How Much Risk Should I Take?
In the world of investments, the way you can assess how much risk is right for you is through a risk tolerance questionnaire or risk assessment tool. Why is it important? Because you want your investments to grow, but you don’t want to worry day and night about them. The assessment of how comfortable you are with risk will help determine how much of your money should be invested in stock (riskier) and how much in bonds (less risky) and cash. A risk assessment tool or questionnaire provides a starting point. When major changes take place in your life—a divorce, death of a partner, birth of a child, etc.—a reassessment is important.
Where can you find a risk assessment tool? Most financial websites and financial advisors provide some sort of tool for evaluation of risk tolerance. A good place to start is an online search for “risk tolerance assessment”. Lots of results! Take a couple assessments and see how they compare. Some might call your risk profile conservative or aggressive or balanced. Please do not put a negative connotation on any of those words. The analysis is meant to help you reach your goals. There is no right or wrong, good or bad. Some assessments might suggest a particular investment mix based on their tool. The Securities Exchange Commission cautions, however, that some providers use their tool to sell products, so be aware of that.
The Other Kind of Risk
Now you have an idea of your risk tolerance—how much risk you are willing to take on. Equally important is your risk capacity. Risk capacity is how much risk are you able to take on. Your ability to take on risk depends a great deal on your household. The following details and others play a role: household income and expenses, the number of people and their ages, how much has been saved and/or invested already, and financial goals and how soon those goals loom on the horizon. Your risk capacity is also affected, in a positive way, by an inheritance or sale of a home or business.
Let’s say that you are a single mom who is a teacher with one child who is a junior in high school. He plans to enter college in two years. You have a small emergency fund but have no other saving and have not started to invest except through your state’s teacher retirement plan. Your child has asthma and has extra medical expenses some of which are covered by your health plan. Even though you may have a high personal tolerance for risk, your ability to take on risk is limited due to your life circumstances. If, however, you know within the next year you will inherit a sizable trust fund from your recently deceased grandfather, your ability to take on risk improves dramatically.
If you are a beginning investor, or if you have started investing but want to know if you are on the right track, look for my book: How to Dress a Naked Portfolio: A Tailored Introduction to Investing for Women. The book is full of understandable financial information, including lots more about risk, and it is packed with helpful resources. Sign up for my weekly emails for more financial information.
When you want to start investing, just as with any other important decision in life, it is important to not only know yourself, but also to be realistic about your circumstances. Polonius wanted his son, Laertes, to be financially sound so no harm would come to him, and he could help others.
What a legacy that would be!
~Beverly J Bowers, CFP®