How Much of Your Portfolio Should Be in Higher-Risk Investments?

If you want to pursue higher returns, one question eventually comes up: how much of your portfolio should you be willing to put at greater risk?

Is it 10%? 20%? 25%?

I don't think there is one percentage that is right for everyone. But there is a fairly simple way to think about the question.

Start by asking what would happen if the higher-risk portion fell significantly.

Suppose you have a $5 million portfolio and are considering putting 10%, or $500,000, into a higher-growth strategy.

As an extreme stress test, assume that investment falls 40%. You would lose $200,000. That's certainly painful, but assuming everything else in the portfolio remained unchanged, your overall portfolio would decline by 4%.

Now suppose you allocated 20%, or $1 million, to the same strategy. A 40% decline would mean a $400,000 loss, or 8% of your overall portfolio.

At 25%, the higher-risk allocation would be $1.25 million. A 40% decline would mean a $500,000 loss, or 10% of your overall portfolio.

These aren't recommended allocations. They simply illustrate how I think about sizing higher-risk investments.

Of course, there is another side to the equation: why take the additional risk in the first place?

The reason is the possibility of meaningfully greater growth. If your retirement, lifestyle and other important financial needs are already well funded, you may decide that a portion of your wealth can pursue a more ambitious objective. Higher returns compounded over many years can potentially multiply an investment several times over, although taking greater risk never guarantees greater returns.

I sometimes think of this portion as a growth sleeve, or an aspirational sleeve.

The appropriate size depends on more than how much money you have. It also depends on your time horizon, what the rest of your portfolio looks like, what you are trying to accomplish, and how you respond to volatility.

Someone might be financially capable of absorbing a 10% decline in their overall portfolio but know that watching it happen would cause them to panic and sell. In that case, the allocation may still be too large.

Another investor may have substantial assets, no need for the money for 10 or 15 years, and considerable experience living through market volatility. That investor may be comfortable allocating more to higher-risk investments.

Neither investor is necessarily right or wrong. Their circumstances and objectives are simply different.

That is why I wouldn't start by asking:

“Should I put 10%, 20% or 25% of my portfolio in higher-risk investments?”

Instead, ask:

“If this portion fell 40%, what would happen to my overall portfolio, and would I still be comfortable owning it?”

Once you can answer that question, deciding how much risk you can reasonably take becomes considerably easier.