Risk Tolerance: Stress-Test Your Portfolio...and Yourself
Many market shocks, such as the downturn at the end of 2018, are short-lived once investors conclude that the economy is on solid footing. Still, major market plunges such as the 2000 dot-com bust and the 2008–09 credit crisis are powerful reminders that we cannot control or predict exactly how, where, or when precarious situations will arise.
Market risk refers to the possibility that an investment will lose value because of a broad decline in the financial markets, which can be the result of economic or sociopolitical factors. All stocks are exposed to market risk. Investors who accept more risk by keeping a large portion of their portfolios in stocks may benefit from higher returns in the good times, but they get hit harder during the bad times. A more conservative portfolio, with a smaller percentage of stocks, is generally less volatile but has lower potential for gain during market upswings.
Your portfolio’s risk profile should reflect your ability to endure periods of market volatility, both financially and emotionally. Here are some questions that may help you evaluate your personal tolerance for risk.
How much risk can you handle financially? Your capacity for risk generally depends on your current financial position (income, assets, and expenses) as well as your age, health, future earning potential, and time horizon. Your time horizon is the length of time before you expect to tap your investment assets for retirement or other financial goals.
The more time you have to keep the money invested, the more likely it is that you can ride out the volatility associated with riskier investments. An aggressive risk profile may be appropriate if you are investing for retirement that is many years away, but you might consider a more conservative approach if you are retiring within the next few years or already retired. However, keep in mind that retirement could last for decades, so while you may begin withdrawing from your savings, your time horizon will not end on the day you say goodbye to the workforce.
How much risk may be needed to meet your goals? If you know how much money you have to invest and can estimate how much you will need in the future, it may be helpful to calculate a “required return” and a corresponding level of risk for your investments. Of course, you don’t have to take on that level of risk, and there is no guarantee that an investment will achieve your targeted return.
Older retirees who have sufficient income and assets to cover expenses for the rest of their lives may not need to expose their savings to market risk. On the other hand, some risk-averse individuals may need to invest more aggressively to accumulate enough money for a long retirement and offset another risk: that inflation could erode the purchasing power of their assets over the long term.
How much risk are you comfortable taking? Some people seem to be born risk-takers, while others are cautious by nature, but an investor’s true psychological risk tolerance can be difficult to assess. A person who describes his or her personality a certain way on a questionnaire may act differently when tested by real events.
Moreover, an investor’s attitude toward risk can change over time, with experience, and age. Novice investors may be more fearful of potential losses. Investors who have experienced the cyclical and ever-changing nature of the economy and investment performance may be more comfortable with short-term market swings.
Market declines are an inevitable part of investing, but abandoning a sound investment strategy in the heat of the moment could be detrimental to your portfolio’s long-term performance. One thing you can do to strengthen your mindset is to anticipate scenarios in which the value of your investments were to fall by 20% to 40% and then develop contingency plans, which might range from standing pat to making strategic adjustments. If you become overly anxious about the possibility of such a loss, it may be helpful to reduce the level of risk in your portfolio. Otherwise, having a plan in place could help you manage your emotions when turbulent times arrive.
The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.