This article was originally published on marcus.com.
What do you do when you see a dip in your portfolio? Do you sell or weather the storm? How you respond can reveal your risk tolerance. Understanding your risk tolerance can help you put together an investment portfolio mix that reflects your financial goals and the type of investor you are.
What is risk tolerance?
Risk tolerance essentially comes down to how much potential loss you’re prepared to handle with an investment and for how long you can stomach that loss. We all hope for as little downside as possible when we invest. But volatility is an innate part of investing, and the (largely unpredictable) dips and climbs will impact the value of your assets.
When it comes to determining your risk tolerance, it’s important to be honest with yourself about how comfortable you are with risk. Are you okay seeing your portfolio shoot up and down with the market? Or would you rather see less volatility?
Why is risk tolerance important? In short, the point of getting to know your risk tolerance is to help you put together a portfolio that reflects both your risk preference and financial goals.
Levels of risk
Like a lot of things in life, risk exists on a spectrum. Generally speaking, though, there are three main levels of risk: aggressive, moderate, and conservative. You can certainly fall in between two levels or closer to one extreme than the other.
If you’re an aggressive investor, you’re typically comfortable taking on bigger risks to potentially score bigger returns. But you’re also aware that bigger risk could come with bigger losses if your investment doesn’t pan out as expected. You’re usually heavily invested in stocks with a smaller percentage, if any, dedicated to safer assets like bonds. Often, younger investors fall in the “aggressive” category, since they’ll have more time for their holdings to recover from any dips in the stock market.
Moderate investors usually have a portfolio that’s a healthy mix of stocks and bonds. Bonds are usually more stable than stocks but also typically have lower returns. If your investment goal is medium term (six to 20 years), it can be a good idea to have a portfolio that’s balanced between risky and safe assets.
Finally, conservative investors like to take on little-to-no risk and therefore may be more heavily invested in less volatile assets like CDs and bonds. That doesn’t mean your portfolio should consist solely of CDs and bonds, but you’ll want the majority dedicated to these generally more stable vehicles.
Your tolerance for risk can change over time. The risk tolerance of a young person just starting out in their career would likely change by the time they reached retirement or even in 10 years. People generally become more conservative investors as they get closer to retirement, when there will be less time for the value of assets to recover if the market dips. But that might not be how you’ll feel as you near retirement. So be honest with yourself and open to changing risk preferences at different stages of life.
What is my risk tolerance?
Now that you know about the different levels of risk tolerance, how can you figure out where you stand? Keep in mind–just about all of these factors are interconnected in one way or another.
- Personal comfort level: Your personal comfort level certainly plays into your risk tolerance. You could have an extended timeline, a robust portfolio and retirement goals 30 years down the line, but if you are someone who cringes every time the market drops, you might not want to invest the way a highly risk-tolerant investor would. Trust your personal comfort level and let it help guide you.
- Goals: Your investment goals can impact how much risk you take on, as well as your timeline. If you have money goals that you would like to accomplish within the next three to five years, you might not be as aggressive in your investments. You want to ensure you have liquid assets available within the next few years. On the other hand, if your main goal is planning for a comfortable retirement and you’ve just entered the workforce at a young age, you could invest much more aggressively because you have more time to realize those goals.
- Timeline: Your timeline will often go along with whatever your goals are. A longer timeline generally means you can take on more risk. If you have a much shorter timeline for your investments, you might want to invest in safer, more stable assets since you won’t necessarily have time to wait for a recovery to make up for lost cash.
- Age: This also goes along with your goals and timeline. You might be wondering–what’s the difference between age and timeline? Well, first of all, they’re definitely heavily connected. But that doesn’t mean your timeline directly equals whatever your age is. You could be in your early 20s and have a long timeline for your retirement goals, but have a very short timeline in saving up for a down payment on a house. It’s important to consider your age, in addition to all of the other factors.
- Size of portfolio: This factor will likely matter less than your personal comfort level, but it’s still worth mentioning. For some folks, the larger their portfolio, the more risk they’re comfortable taking on. Of course, these are just generalizations. A young investor can shy away from risk just as a retiree can be willing to take a lot of chances. The biggest thing to know is that risk–and really, finances–are personal.
Not sure what your comfort level is? Risk tolerance questionnaires can be found online or you might request one from your financial advisor. If Ayco is offered through your employer, speak with a coach to walk through a risk tolerance assessment and determine what type of investor you are.
How could my risk tolerance impact my returns?
Higher risk equals potentially higher returns. Which makes sense—if you’re willing to take on more risk in the hopes of bigger returns, that seems like a fair trade-off. But, the reality is rarely quite that simple.
For example, as we mentioned earlier, stocks generally have higher returns when compared to bonds. But we also know there’s volatility in the stock market. You can’t rely on past performances to guarantee future returns. Knowing your risk tolerance can help keep you realistic about your returns and help build a deeper understanding of volatility in the market.
On the other hand, if you can’t handle a lot of volatility and are more risk averse, your returns may be more predictable. But those returns may also be potentially smaller than they would be with riskier investments.
At the end of the day, your risk tolerance can guide you to the right personal investment mix. Sticking with that mix, and reassessing from time to time, is key to meeting your financial goals and having greater peace of mind.
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