We all know that the market is volatile. There are a lot of ups, downs and unexpected events, which is why the market is often compared to a roller coaster. And like roller coasters, some of us are comfortable with or even enjoy the thrill, while others prefer a less frightening and more stable ride.
Being invested in the market is an emotional experience and carries with it a degree of risk. We all want to make money and see our investments soar. But we have to ask ourselves: Are we willing to take on risk in order to achieve those returns?
This is an important trade-off that all investors must face: risk vs. reward. Historically, stocks have provided greater returns, but they also come with greater risk. On the other hand, bonds are not as risky, but they usually don’t provide as high of returns as stocks. Once you have decided how much risk you want to take, you can determine how your portfolio will be constructed. The more risk you are willing to take, the more stocks your portfolio may have. If you choose to take a more conservative approach, your portfolio may hold more bonds.
Your Risk Profile
Almost all financial institutions offer risk tolerance questionnaires that can help you develop your risk profile. The questionnaire typically results in a score indicating whether you should be conservative, moderate or aggressive in your investing approach.
This tool can be very helpful, but it shouldn’t be the only deciding factor. For example, if the questionnaire indicates that you are a moderate investor, but your stomach ends up in knots every time the market declines, you may decide that a conservative allocation is more appropriate.
In addition to this emotional element, there are other items you should consider when determining how much risk you should take in your portfolio. For instance, how much emergency cash do you have set aside? What are your investment objectives?
When will you need the money? Let’s discuss these factors in more detail:
It’s important to have a certain amount of cash set aside for emergencies, in case you become unemployed or face an unexpected expense. Having extra funds on-hand will help you avoid early withdrawals from your retirement funds, which can result in steep penalties.
If you do not have a substantial emergency fund set aside, you might consider being less risky and more conservative when it comes to your portfolio. For instance, if you are invested in an aggressive portfolio and the market goes down at the same time you need your money, your balance could suffer quite a bit.
Your investment goals can also have an impact on the level of risk you take with your investments. If you’re only focused on growing your investments, you may choose a more aggressive allocation. Perhaps you’ve had a bad experience with the market in the past and only want to protect what’s there without seeing a lot of movement in your account. In this case, you may want to be more conservative.
How much time do you have until you need the funds that you’re investing?
The amount of time you have to invest your money plays a large role in the amount of risk you take in your portfolio.
If you are young and saving for retirement or starting a college savings account for your future child, you can afford to take on more risk. The more time you have, the longer your funds have to recover if the market goes down. However, if you’re investing to achieve a short-term goal, you may want to be more conservative.
The closer you are to needing the funds, the less volatility you want to see.
Once you’ve determined your risk tolerance and corresponding investment allocation, it’s important to stay invested. Often, our emotions will kick in and tell us otherwise. Allowing emotions to drive your investment decisions can derail your ability to meet your goals. For example, we often feel great when the market is doing well. But as soon as the market starts to decline, fear sets in, and we worry that it will continue to plummet.
A natural reaction to this is deciding to move to cash in order to avoid additional losses. However, it’s important to resist the urge to panic. No one has a crystal ball that can predict the right time to get back into the market. And while you’re waiting for that right moment to come along, you might miss out on the recovery, which could translate into missed opportunities for growth. So the point is, make sure that you are comfortable with the expected range of returns — the highs and the lows — when figuring out your risk tolerance and evaluating potential portfolios.
And finally, remember that your risk profile will not always remain the same. As you get closer to retirement, or as life circumstances unfold (marriage, children, sickness, etc.), your profile can also change, and you might need to make adjustments to your portfolio. An investment advisor can help guide you through these decisions and keep you on track to achieving your goals.