If you’re like a lot of investors, you may have trouble quantifying the level of risk you are comfortable taking on in your portfolio. Do you like to play it safe, staying in conservative investments even if it means potentially missing out on bigger returns? Or are you willing to take on more risk in the hopes of capturing higher gains? If you’re not sure where you land on the spectrum, consider the following eight tips to help define your views on investment risk:
1. Define your goals. Your financial plan should be structured to help you get from where you are now to where you’d like to be with key goals, such as saving for your child’s college education or retirement. Your investment strategy should be a key part of this financial plan. Define exactly how much money you will need to save, and when you will need it by. When your goals are crystal clear, it can be easier to weigh the various risks and choices you must make to achieve them.
2. Consider the general market environment. It seems fair to say that investors’ willingness to accept risk increases in periods when the stock market has performed well for an extended period of time. In the past decade, stocks have generally been on the upswing. On the heels of such a positive market, investors’ level of confidence about owning assets that are subject to fluctuation may be higher. By contrast, investors sometimes become more skittish in periods when markets are struggling. Confidence in stocks and other variable investments tends to decline when the market is not performing well.
3. Accept market moves as normal. It’s a known fact that stock markets move up and down – sometimes significantly – which means there’s always risk that a particular investment could lose value. Keep in mind that historically markets have recovered, and the reward potential of investing in future growth of global businesses remains strong. Prepare yourself for the fact that investing is not a smooth upward climb, and a smart strategy can help the market moves work in your favor.
4. Recognize that time is one of the biggest influences on risk tolerance. If you have a decade or more to reach your goals (such as retirement), you likely can ride out market downturns or even extended flat or negative markets. If you expect to reach your goals (such as a new home) in the next few years, you may need to think more about how to protect your investments against the impact of market moves. With this in mind, your risk tolerance will likely adjust as you get closer to achieving various goals.
5. Trust your instincts, but don’t make decisions solely based on emotions. If you are worried about what’s ahead in the markets or how your finances would fare if another Great Recession occurs, it may be time to reassess your portfolio to take some risk off the table. Yet, it’s important to not be overly swayed by day-to-day headlines. Look for consistent, long-term trends or events that impact market fundamentals before considering action. And, be sure that any decisions you make align with your financial goals, as defined in tip #1 above.
6. Consider purchasing power risk. Inflation is always a factor worth considering. Simply stated, your money more than likely won’t be worth as much in the future as it is today. It is important to own investments that can help your asset base at least keep pace with inflation, and hopefully grow faster than the cost of living.
7. Be mindful of interest rate risk. Fixed income instruments such as bonds carry their own risks, one of them being that if interest rates rise, bond values will decline. Given that yields are slowly rising from historically low levels, this risk may be more significant today.
8. Explore ways to stay invested in the market while mitigating some of the risk. Maintaining healthy diversification across a variety of asset classes is a key way to manage risk. Staying invested for the long-term and not trying to time the market is another. Dollar-cost averaging, or investing consistent amounts of money at regular intervals, rather than investing lump sums at one time, can help you remain committed to your saving strategy. Additionally, products (such as variable annuities) that allow you to continue to participate in the market’s growth potential while locking in gains may also be worth considering.
Given your timeframe, current savings, income and other financial priorities, how much risk are you willing to take to achieve your goals? This is the ultimate question you need to answer to determine your risk tolerance. If you want help deciding whether your portfolio is appropriate for your feelings on risk, consult a financial advisor who can provide a second opinion.