When it comes to investing, many people look at risk and immediately think, “that’s bad!” They view risk as something to avoid or reduce. To a point, that’s correct; we never want to put an investment portfolio at risk unnecessarily.
But you cannot have a reward without taking on some risk. Life is inherently risky, and risk is not something we can eliminate.
Risk is what allows us to grow and add to our wealth over time.
The answer isn’t to avoid risk, but to properly manage it so that we can earn the return we need to reach our goals. Managing the chance of loss or a negative outcome requires that we know what a reasonable bet looks like, and to make that bet when we can — while also recognizing what needlessly puts a portfolio at risk and pulling back from those more speculative gambles.
To help you identify what’s a worthwhile risk, what’s unavoidable but manageable, and what’s too much risk that there’s no reason to take, look for these 3 signs that your risk calculation might need some fine-tuning.
You Know Your Risk Tolerance, But Not Your Risk Capacity
Most people have heard of “risk tolerance.” That’s your emotional comfort level with risk.
Fewer people have heard or ever thought of their risk capacity, which is a far more important measure when it comes to taking appropriately-calibrated chances with your money.
Your risk capacity is your ability to afford or absorb when the downside is realized and you take a loss of capital.
You could put your portfolio at risk if you have a very high risk tolerance that exceeds your capacity to dive into very risky investments.
If you have a very high net worth, your risk capacity is probably higher than average. You can literally afford to lose money without that loss derailing your overall financial goals.
Similarly, you could have a high risk capacity even if you have less financial means, if you don’t have (m)any obligations, responsibilities, or extremely expensive goals you must achieve.
Someone who is single with a very stable job with no plans to retire early, no debts, and no dependents is going to have a higher risk capacity than someone who is married with two kids, a mortgage, and wants to retire at 50 years old.
Knowing your risk tolerance is important; you have to adjust your portfolio so that you can tolerate whatever volatility you might see in the short-term in order to make it to the long-term goal.
But you must also take the extra step of calculating and understanding your literal capacity to take a risk.
If you don’t have the capacity to afford to realize the downside of a particular gamble you want to make, you can’t expose yourself to that situation (at least not fully).
Risk capacity works the other way, too!
If you are working hard to avoid risks even though you have the capacity to handle them, you may actually be costing yourself in opportunities and real dollars.
Not taking enough risk means you could fall short of goals that are really important to you, simply because you were too scared of potentially seeing a loss (even though you could afford that loss).
You Could Put Your Portfolio at Risk If You Hold Too Much Cash
There may be no financial advice as common as “save [more] money.” But a strong savings habit can lead to accidentally exposing your financial life to a surprising risk: excess cash.
There’s a difference between how much cash you need, and having too much cash either in the bank or sitting within your investment portfolio or retirement accounts.
Cash drag happens when you have excess cash that is literally costing you in terms of potential returns, opportunities, and future purchasing power.
In general, “enough” cash means you have sufficient liquidity in your accounts to address three main needs or concerns:
- Your normal monthly or quarterly spending (depending on how you get paid and the structure of that income)
- Unexpected events or emergencies (which is why you need an emergency fund made up of 3 to 6 months’ worth of expenses)
- Short-term goals or spending needs (like an upcoming trip you plan to take in 6 months or a home repair you plan to make next year)
If you need money to pay for something or to fund a goal between now and the next 5 years, keeping those funds in cash makes sense. Having cash for those needs or wants, a full emergency fund, and money to handle your normal cash flow is enough.
Anything over that amount could be excess cash that exposes your overall financial plan to inflation risk and incurs opportunity costs.
Even in a high-interest environment, inflation consistently outpaces returns on almost any savings account. (And historically, the return on cash is about 1%; inflation is about 2-3%.)
That means your cash is slowly losing value — which in turn reduces your future purchasing power, making it harder to achieve your biggest and longest-term goals like making work optional and funding the lifestyle you want now and down the road.
That cash is also not doing anything to earn returns. Time is probably anyone’s absolute most valuable asset, and your money needs time in the market in order for your portfolio to leverage the opportunity to earn compounding returns.
Time IN the market beats TIMING the market.
The best moment to start investing was almost always “yesterday.” That’s how powerful time in the market is. The next best time? Today.
It may feel riskier to invest than to keep your money in a “safe” place like cash, especially if the market is volatile — but remember that we actually expect short-term volatility in the market.
We know that’s part of how a normal market functions, which is why we deploy tactics to manage market risk.
Diversification is a huge part of how to properly manage what would otherwise put your portfolio at risk.
Having some cash is critical to financial stability and flexibility. But once you have enough to manage the present and near-term future, extra cash can turn from a source of safety to something that actually puts your portfolio at risk.
Don’t let cash drag cost you in terms of opportunities and purchasing power. Know what you need, and then get any excess cash off the sidelines and invested into assets that will help you grow wealth over time.
Concentrated Positions Could Put Your Investment Portfolio at Risk
Holding single stocks or highly concentrated investments increases volatility, decreases diversification, and opens you up to the possibility of bigger losses than you can actually afford to realize.
A concentrated position isn’t inherently a bad thing. Again, risk and reward have a relationship. The more risk you take on, the higher a potential reward.
The key word there is potential. There are no guarantees.
Before you take an oversized bet on a specific segment of the market or accept an outsized position on a security in hopes of seeing big returns, you need to be quite certain you can take the hit if the opportunity does not pan out.
Typically, we recommend our wealth management clients limit their exposure to any one stock to no more than 5 percent of their liquid net worth.
And that is in conjunction with holding a properly, globally diversified portfolio of investments and cash with the other 95 percent of their wealth.
As we explained in a recent piece for Forbes,
Everyone thinks they’ve got the winning lottery ticket. But if you look at the S&P 500 from 2000 to 2021 in five year rolling periods, you’ll see:
- 100% of the stocks on that index dropped by at least 20% at some point in the period
- 63% of the stocks on the S&P 500 went down by 40% or more
If you zoom out even more and look at the Russell 3000 index from 1987 to 2024, you’ll also notice that only 33% of those stocks outperformed. That suggests you might have a 1-in-3 chance of picking a winner. Guessing wrong is costly:
- 39% of those stocks lost value in the period
- 27% failed to keep pace with the benchmark (but at least provided a return; still a tough pill to swallow if you see how much more you could have earned had you just been properly diversified!)
Pinning all your hopes on any one stock taking off is opening yourself up to larger and larger probabilities of experiencing losses.
You make your finances — and your future — very vulnerable and exposed to the whims of a very specific entity or sector of the market if you do not carefully manage concentrated positions within your portfolio.
Failing to diversify is a needless risk that you don’t need to take in order to grow your wealth and achieve your goals.
Before you choose to turn away from a good diversification strategy, make sure you acknowledge how much you could jeopardize your ability to increase your net worth by putting your portfolio at risk like this.
You Cannot 100% Avoid Putting Your Portfolio at Risk, But You Can Properly Manage the Risks Inherent to Investing
The goal here is not to avoid all risks, or never see the potential for a loss (or even realize an actual loss).
No one gets through life unscathed, and you cannot separate reward from the risks required to earn it.
What you can do is get a systematic approach in place from the start. Don’t wait until something goes wrong or you feel overwhelmed by emotion or stuck in analysis paralysis.
The best time to make a plan is when things are going well, when you feel calm, can think clearly, and be most objective.
That is when you want to design and deploy a long-term strategy that you can then rely on when markets (or life) inevitably take a tumble or an unexpected left turn.
Bear in mind that market volatility is a normal part of a healthy market and all investments, however “safe” they may seem, come with some degree of risk.
Data suggests that your probability of success is better if you are a long-term investor. You need time in the market, which means you need to stay in the market when the market rocks your boat.
Develop a rules-based system that accounts for both your tolerance and capacity for risks, emotionally and financially, and let that plan guide you through tough times so you can do what’s most important for almost any investor: stay in your seat long enough to let your money work for you.