How Much Risk Should You Take When Building a Portfolio?

Building a portfolio is no easy job. You don’t just pick some random assets, purchase them, and start making a return on an investment. You need to identify the ones that make sense for you, come up with strategies, and establish the amount of risk you’re willing to take. If you welcome digital assets to your portfolio, learning how to buy crypto is one small part. The more challenging steps come after the purchase because you need to decide how exposed your portfolio should be to risk, how much volatility you can tolerate without panicking, and what other assets to add to survive a bad market without destroying your long-term plans.

There is no magic risk percentage that works for all investors; you decide the appropriate level of risk depending on your time horizon, goals, financial situation, ability, and willingness to withstand losses. Crypto specialists state that asset allocation is personal and should reflect both your investment timeframe and risk tolerance.

We know that it doesn’t sound as exciting as finding new cryptocurrencies. In fact, it might sound 100x less exciting. But establishing how much risk you should take when building a portfolio is quite useful in the long run.

Establish How Much Money You Need

Before you decide how much money you can take when building an investment portfolio, you separate your investment money from essential money. If you need the money for rent, an emergency expense, a mortgage payment, or a major purchase next year, putting it into highly volatile assets can create a nasty problem. Markets don’t care that your financial goal has a deadline.

Your portfolio could drop 30% and stay there for weeks before recovering. Your bills or upcoming house deposit cannot wait for the market to feel better.

The same distinction is available when discussing time horizon. If you have a long time horizon for the investment to generate a return, you might tolerate higher volatility, but if you need money for other short-term goals, then you won’t find risky investments as attractive.

Risk Tolerance Isn’t Just About Your Personality

Some describe themselves as high-risk investors because they’re not afraid of losing money. But the lack of fear tells only part of the story. Risk tolerance implies both your ability and willingness to absorb losses. Risk tolerance is the ability and willingness to lose some or all of your investment in exchange for potentially greater returns.

We’ll picture two investors. One is comfortable with seeing their portfolio drop 30%, but they have an emergency fund and expect to need the invested money within two years. The other hates it when there are red numbers in their portfolio even if they have stable finances and a 20-year investment horizon.

Can you identify the one who realistically tolerates more portfolio risk? Maybe the second one, even if they are psychologically more cautious. So, you shouldn’t decide your risk tolerance based only on your personality. Your financial circumstances are determining.

Your Time Horizon Plays An Important Role

Time is one of the most important variables to consider when building an investment portfolio. If you’re investing for a goal decades away, you have more opportunity to ride through market cycles. If you need the money within a few years, a major downturn at exactly the wrong moment can become much more damaging. This is why no one can provide the recipe for the universal safe portfolio.

You might be a 25-year-old investor who’s saving for retirement, or maybe someone saving for a home purchase in five years. Depending on your goal, you have different risk requirements, even if the salary might be the same in both cases.

If you have a longer time horizon, you will find it more comfortable to invest in volatile assets because you have more time to withstand market ups and downs. With the time horizon factor in mind, you need to answer the following question:  “How much risk can I take without jeopardizing the goal this money is supposed to achieve?”

Divide The Investment Into Layers

Seasoned investors reveal that risk is easier to understand when you divide your money into layers. The foundation of the portfolio should sit on the financial safety net: emergency savings and money you need to cover near-term expenses. The other layers include long-term investments. Within your portfolio, you can have different levels of risk, placing the diversified investments at its core and the more volatile assets in smaller positions. When you adopt this approach, you don’t leave exciting investments aside, but make sure that your portfolio isn’t fully made of them.

For example, you might have a diversified long-term portfolio and separately allocate a smaller amount to digital assets because you also want some kind of exposure to the crypto sector. Your personal preference for crypto defines your portfolio, but you understand that this kind of volatile asset shouldn’t be your all-or-nothing.

Don’t Confuse Risk With Potential Return

This is the part where investing can get a little bit psychologically tricky. You know that high potential returns usually come with a greater risk and that increased risk doesn’t automatically mean a better return. So when someone says that an investment can generate a high return and there is almost no downside to it, your skepticism kicks in. Or at least, it should. Seasoned investors have always noted that higher expected returns most often come with a greater risk of significant losses, and it’s best to understand the products you want to welcome to your portfolio before actually putting money into them.

This matters greatly when speaking about crypto because a token that could theoretically rise 500% could also lose most of its value in the same time frame, or quicker.

The Right Amount Of Risk For You Is The Amount You Can Actually Afford

It might feel a little uncomfortable to read this, but the mathematically attractive portfolio isn’t necessarily the right portfolio if you can’t stick with it. You should stress-test your reactions to different scenarios to figure out how much risk you’re willing to take.