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.
Start by asking yourself why you’re investing. While people invest for a variety of reasons, some common goals include:
Determining the why of 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.
Your investment goals can help you establish the time horizon for your investments.
Generally, the longer the time horizon, 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 7 percent per year on average, accounting for inflation.
A shorter time horizon 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.
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 derail their portfolio overall.
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.
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.
Learn more about how risk tolerance and time horizon work together in investment strategies by age.