Risk tolerance is the amount of market volatility and loss you’re willing to accept as an investor. Determining your personal risk tolerance is perhaps the most fundamental step you can take in deciding what types of investments to make.
These five questions can help you assess your risk tolerance.
1. What are your investment goals?
Start by asking yourself why you’re investing. While people invest for a variety of reasons, some common goals include:
- Retirement
- Buying a house
- Paying for your child(ren)’s education
- Financial independence
Determining thewhyof investing is the first step toward understanding how much risk you’re willing to take on. Plus, having a goal in mind can help you assess your timeframe and estimate how much money you’ll need.
2. What's your time horizon?
Your investment goals can help you establish the time horizon for your investments. Your time horizon is when you plan on using the money you've invested.
- Generally, the longer the time horizon, such as saving for retirement, the more risk you can take on. If your investments lose value, you have time for them to recover. While downturns do occur, and past performance is no guarantee of future results, the stock market has historically returned about 8.5% per year on average, accounting for inflation.1
- A shorter time horizon, such as saving for a down payment on a house, means your investments have less time to recover from a potential downturn. If your goal is to earn a big return in a short time period, you’ll need to be comfortable with risk: If the market falls suddenly in your timeframe, you may not meet your goal on time.
3. How comfortable are you with short-term loss?
Investments can fluctuate in the short term. It’s important to remember that with stocks and similar investments, your shares may decline in value, but you don’t realize the loss until you sell the investment. If you need your money in the near-term, you may be forced to sell at a loss. Investors with a longer time frame can hold onto the investment in the hopes it will recover and potentially increase in value with time.
Given your goals and your time horizon, are you able to absorb a loss in the short term? Risk-averse investors may choose to invest in a diverse portfolio of stocks, bonds and real assets, so that a pullback in one asset class doesn’t necessarily derail their portfolio overall.
4. Do you have non-invested savings?
Regardless of your risk tolerance, it’s important to have some savings set aside in liquid accounts. If you face an emergency, like a job loss or accident, you can easily access cash without having to liquidate any investment accounts.
However, if you’re keeping a large portion of your savings in cash because you’re nervous about investing, this is likely a sign you’re risk averse.
5. Do you plan on tracking your investments day-to-day, week-to-week, or only semi-regularly?
Suppose you invested in an index fund that seeks to track the Dow Jones Industrial Average or the S&P 500. Would you anxiously scan the business section of your paper or follow the ups and downs through an app on your phone?
If so, are you doing it because you’re nervous, or because you’re excited about new investing opportunities?
If every down day in the market makes your stomach drop, a diversified portfolio and a focus on long-term goals can make the inevitable down days more palatable. Keep in mind, diversification and asset allocation do not guarantee returns or protect against losses.
If you’re actively looking for investments and buying opportunities when you track the market, you might be willing to take on more risk. In that case, be sure to research your investments. While a high tolerance for risk can pay off, reacting solely to headlines can lead to unnecessary risk.
While every investment comes with risks, understanding the balance of risk and reward that works for you is the basis for building a diversified portfolio. Consider working with a financial professional to assess your risk tolerance and develop a plan that helps address your specific financial goals.
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The article revolves around the critical aspect of risk tolerance in investment decisions, emphasizing the need for investors, especially those new to the game, to carefully evaluate their comfort level with market volatility and potential losses. Let's delve into the concepts highlighted in the article:
1. Risk Tolerance:
- Definition: Risk tolerance refers to the extent to which an investor is willing to endure market fluctuations and financial losses.
- Significance: Determining risk tolerance is fundamental in shaping an investment strategy that aligns with an individual's financial goals and psychological resilience.
2. Investment Goals:
- Importance: Identifying investment goals, such as retirement, buying a house, education funding, or financial independence, is the foundational step in gauging risk tolerance.
- Connection: The why of investing provides clarity on the level of risk one can comfortably undertake to achieve specific financial objectives.
3. Time Horizon:
- Definition: Time horizon refers to the duration an investor plans to hold an investment before needing to access the funds.
- Relation: Longer time horizons, like saving for retirement, allow for a higher tolerance for risk, considering the potential for market recovery over time.
4. Comfort with Short-Term Loss:
- Crucial Aspect: Short-term market fluctuations are inevitable, and investors must assess their ability to withstand temporary losses.
- Strategy: Investors with longer time horizons may weather short-term losses with the expectation of eventual market rebound.
5. Non-Invested Savings:
- Emergency Preparedness: Regardless of risk tolerance, maintaining liquid savings is essential for handling unforeseen emergencies without liquidating investment assets.
- Indicator: A large portion of savings in cash may indicate a more risk-averse approach to investing.
6. Tracking Investments:
- Frequency: Monitoring investments daily, weekly, or semi-regularly reflects an investor's engagement level.
- Psychological Aspect: Reacting nervously to market fluctuations may indicate a lower risk tolerance, while excitement may signal a higher risk appetite.
7. Professional Guidance:
- Recommendation: Working with a financial professional is suggested to assess risk tolerance and develop a tailored investment plan.
- Acknowledgment: While diversification and asset allocation are mentioned, the article highlights their limitations in guaranteeing returns or preventing losses.
In conclusion, the article stresses the importance of aligning investment decisions with personal risk tolerance, emphasizing that understanding this balance is the foundation for constructing a diversified portfolio. If you're seeking to embark on or refine your investment journey, considering these factors in consultation with a financial professional is a prudent approach.
