After all the pain caused by market volatility over the past year, how much have we learned about our risk tolerance? We know we’re much happier when the stock market is going up rather than down. We probably realized our portfolios were too risky back in 2020 and wish we had made different choices back then. But how many of us have assessed our risk tolerance and made portfolio choices based on that assessment?
You are trying to assess your emotional tolerance for risk or how much price volatility you are comfortable with. Some questions that can help you gauge that risk tolerance include:
What long-term rate of return do you expect on your investments?
This will help you determine the types of investments needed to meet that target. Review historical rates of return over a long time period to see if your estimates are reasonable. High return expectations can cause you to invest in asset classes you aren’t comfortable with or that you may be tempted to sell frequently. A better alternative may be to lower your expectations and invest in assets you are comfortable owning.
What length of time are you investing for?
Some investments, such as stocks, should only be purchased for long time horizons. Using them for short-term purposes may increase the risk in your portfolio since you may be forced to sell during a market downturn.
How long are you willing to sustain a loss before selling?
The market declines of the past three years will indicate how comfortable you are holding investments with losses.
What types of investments do you own now, and how comfortable are you with those investments?
Ensure you understand the basics of any investments you own, including the historical rate of return, the largest one-year loss, and the risks to which the investment is subject. If you don’t understand an investment or are not comfortable owning it, you may be tempted to sell at an inopportune time. Over time, your comfort level with risk should increase as your understanding of how risk impacts different investments increases.
Ensuring your investments are compatible with your risk tolerance is an important component of your investment strategy.