When the market is going up, it’s easy for investors to think they’re more comfortable with risk than they actually are. Eventually, volatility returns and stocks go into a swoon. That’s often when people discover their true risk tolerance.
It’s better to determine at the outset the level of risk that’s appropriate for you and to be able to stick to your investing strategy—come what may. To help with this, you might ask yourself these three questions.
1. How much can I stand to lose emotionally?
The assets that offer the highest potential reward are often the riskier ones. Portfolios with larger allocations to stocks typically deliver higher returns over time, but they are also more volatile. If you can’t bear to see your portfolio plummet in value, you should choose a more stable investment mix.
On the other hand, reducing your exposure to stocks and other relatively high-risk, high-reward assets during your peak earning years comes with its own kind of risk: falling short of your goal.
To help manage your emotional response to market volatility, consider cutting back on how often you review the performance of your long-term accounts. Research suggests that the less often people check their investments, the more risk they will be comfortable taking.
2. How much can I stand to lose financially?
Time is the primary issue here. Those who have a decade or more before they expect to tap their savings can likely wait out some short-term volatility. For someone who may need the money sooner—in, say, five or fewer years—a market downturn can be devastating.
3. How well do I know myself?
It’s worthwile to try to square your financial capacity for risk with your emotional tolerance for it. You might try asking someone close to you to rate your risk tolerance. A spouse or a close friend may be able to identify patterns of behavior that you don’t recognize in yourself. Financial advisors are also well suited to this role. Their experience with a broad range of clients can lend perspective on where you fall along the spectrum of risk tolerance.
Don Daigle is a Financial Consultantat Charles Schwab with over 30 years of experience helping clients achieve their financial goals. Some content provided here has been compiled from previously published articles authored by various parties at Schwab.
The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Diversification asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.
Don Daigle
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