Evaluating Risk Tolerance
October 27, 2011
How you divide your investment portfolio among stock, bond and cash investments is called asset allocation. It can serve as a logical starting point for your investment strategy. Individuals should base their asset allocation on their time horizon and risk tolerance.
With this as a starting point, you can review your risk tolerance. Here are some questions that can help you understand how you feel about risk. There are no right or wrong answers and the results may serve as a mere starting point, not a conclusion.
You have done your homework and bought $5,000 of a stock you believe has very good growth potential. Two months after your purchase, the entire stock market declines and your stock is down 15%. Do you:
A -- Sell all of it.
B -- Sell half of it.
C -- Hold it.
D -- Buy more.
You work for a small and growing technology company. The company's owners are offering the employees the opportunity to buy stock in the company. They anticipate taking the company public sometime in the next three to five years. If you buy the stock, you will have to hold it until a public market exists, and it pays no dividends. Do you:
A -- Buy none.
B -- Buy one month's salary's worth.
C -- Buy three month's salary's worth.
D -- Borrow money and buy a year's salary's worth.
Which would you rather have done?
A -- Invest in a money market fund currently paying about 4%.
B -- Invest in an electric utility stock paying a 3% dividend with the potential for modest growth.
C -- Invest in a portfolio of blue chip companies with a chance of earning average market returns.
D -- Invest in two risky medical technology companies with a chance of significant gains or losses.
You are on a TV game show. Which would you choose?
A -- $5,000 in cash.
B -- A 50% chance of winning $10,000.
C -- A 20% chance of winning $25,000.
D -- A 10% chance of winning $100,000.
Now let's go back and evaluate your answers. In each case, A answers are worth 2 points, B answers are worth 4 points, C answers are worth 6 points, and D answers are worth 8 points.
Add up the points for the answers you selected. The higher your score, the more willing you are to assume higher risk to earn higher returns. The midpoint of the possible scores is 20.
If you are a risk avoider, with a score between 12 and 18, your desire may be to reduce your equity exposure with increases in bonds and cash. If your score is less than 12, you don't like risk at all. Your desire may be reducing your equity exposure.
The Trust & Asset Management experts at Home Federal Bank are here to help you assess your risk tolerance in more detail while providing wealth management tools with sound advice. Contact us to today to review your current allocation and verify it matches your objectives.
Reviewing your allocation on a periodic basis is important. You may have added more funds to certain sectors, you get older and your risk tolerance can change. Rebalancing generally makes sense if your actual allocation has deviated more than 5% from your objective. By working with Home Federal Bank, you will not only get regular evaluation of your allocation, but the comfort of working with a financial leader in our region.
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