RISK ANALYSIS

One of the topics that comes up during our discussions with clients is how much money should be put at risk in a given investment strategy.

We like to help answer this question by asking you to imagine that designing your investment strategy is a bit like building a house.

A house, among other things, has a foundation, walls and a roof.  Continuing with the analogy, if we were going to describe the characteristics of these parts of a house, we would first agree that the foundation is the most stable part of the house.  It’s also the most important.  Any good engineer or architect makes sure that the foundation is built using materials and techniques that will outlive the house.  Investing in the best materials for the foundation is money well spent.

The walls are also very important, and must be strong and stable.  Load bearing walls support the house, interior walls divide the space into rooms, etc.  This is also very important, and it makes sense to use quality materials to keep the walls strong.  But we could lose part of a wall or remove an interior wall and still keep our home intact.

Finally, we have the roof.  It’s important that your roof keeps the weather out and protects the rest of the house from damage.  However, it’s expected that even a good roof must be replaced every ten years or so.  Every now and then we are going to lose some shingles or tiles.  Not a huge disaster, right?  We replace the parts we need to replace or even the entire roof, but we expect that’s the normal risk we take owning a home.

Getting back to investing, what kind of financial products would constitute your foundation?  We’re looking for stable products like: pensions, fixed annuities, CDs and cash.  These funds won’t lose value but they also won’t grow very quickly.   There’s very little risk here.

The rest of your money should be placed under a certain amount of risk which gives us the opportunity to grow our money.  These are moderately aggressive products like stocks, real estate investment trusts, bonds, etc.  Our financial roof is made up of things like tech stocks, gold, oil and aggressive mutual funds.

How much money should you place at risk?  To answer this question we like to refer to a well established maxim called the Rule of 100.  Basically this rule says:

“A person should subtract their current age from 100 to determine how much “red money” to place at risk.”

Let’s assume for this article that you are 55 years old.  Following the Rule of 100, we would comfortably recommend that you invest 45% of your money in moderate and aggressively risky investments.

Of course, there is a lot more to an investment strategy.  But this answers the question of how much of your money should be kept safe and how much should be risked intelligently in order to provide income, protect your principle and allow you to benefit both when the market is up and when it is down.