Investors, How Much Risk Can You Stand?
The investing world is full of unknowns these days. We're grappling with a new--and very different--administration in Washington, along with more-familiar concerns about the economy, corporate earnings and geopolitical developments. The only certainty is that volatility will escalate, so be prepared for a few gut checks as the market zigs and zags. Knowing more about your tolerance for risk can help you design a portfolio that will ensure you can meet your goals without losing sleep.
Risk tolerance is a measure of both your ability to take on risk and your willingness to do so. Ability has to do with your finances--the investment returns you require to meet your goals, how much you can afford to lose in a market downturn, how much time you have to make up losses and so on. Those considerations will be factors in how you divide your money among stocks, bonds and other investments and which companies you favor. Your willingness to take on risk is behavioral, emotional and psychological--it's how comfortable you are with the portfolio decisions you've made. "Sometimes the ability to take risks conflicts with the willingness to take risks," says Tyler Nunnally, a strategist at FinaMetrica, a firm that develops risk-tolerance tests for investment advisers to use with their clients.
Such conflicts can derail an investment plan faster than you can say "Sell everything!" Says Nunnally, "If investors are taking on more risk than they can emotionally tolerate, they'll hit the panic button and sell at the worst possible time." If that sounds like you, then you need to ratchet down the aggressiveness of your portfolio, whether by transferring some money from stocks to bonds and cash or perhaps by trading in some of your small-company upstarts for big, brand-name blue chips.
See Also: 8 Risky Stocks That Could Make You Rich
But recognize that such de-risking comes with the trade-off of diminished rewards. Maybe you'll have to retire at age 67 instead of 65, or maybe you'll decide to spend less and save more. Conversely, you might have an appetite for adventure when it comes to investing, but if you are only a year or two from retirement (or some other goal), then your capacity for risk taking with the assets required to meet that goal is virtually zero.
Nature, not nurture. One misconception about risk tolerance is that it varies with whatever is going on in the market. In fact, the psychological aspect of risk tolerance is just as much a part of your personality as, say, introversion or extroversion. Risk tolerance remains remarkably stable during market gyrations and throughout one's lifetime (although major life events, such as marriage or the birth of children, can change your appetite for risk). Interestingly, risk tolerance is not necessarily consistent in all aspects of one's life: You could be a stock market ninny who skydives or a gambler who likes to hug the right lane and drive just below the speed limit.
What can change with the market is your perception of risk, which wanes in boom times and waxes as markets head south. In other words, whatever your tolerance might be, a turbulent market can make you overestimate the level of risk. The best way to avoid any rash decisions is to maintain a well-diversified portfolio, which tends to smooth out returns over time, and to think long term. Don't obsess over your account balances, and turn off TV financial commentators if they spook you.
The good news is that for many investors, extreme risk taking or risk avoidance is on the way out, according to 401(k) plan data from Fidelity Investments. Fifteen years ago, some 45% of savers had either 100% or 0% of assets invested in stocks. Now, only 12% of accounts are at those extremes, thanks in part to the advent of target-date funds, which automatically diversify holdings across assets that are appropriate for a specified time horizon.