There are millions of different investments you can buy, and they all require you to consider the same key trade-off: risk versus return.
Generally speaking, the higher the potential returns from your investment, the more likely it is to drop in value precipitously. When looking to maximize the return on your portfolio, ask yourself: what would a significant decline in my investments do to me?
The question requires a multi-faceted answer – one that examines both how a drop in your portfolio would materially affect your finances and how you react emotionally to losing money.
Many investors have been able to answer this question lately. The broader stock market fell almost 24% between January and mid-June, and many individual stocks and more volatile assets, such as cryptocurrencies, fared much worse.
If recent market volatility is hurting you a little more than you thought, consider taking a moment for some soul-searching, says Christine Benz, director of personal finance and retirement planning at Morningstar.
“A lot of people entered the market in 2020 and 2021 just because it was growing,” Benz told CNBC Make It. “Now is a good time to take a deep breath, take a step back, and think about the appropriate amount of risk to take on in your portfolio.”
Here’s how to make sure you’re investing with the right level of risk, according to market experts.
Understanding risk capacity and risk tolerance
Back to the central question: what would a sharp decline in the value of your portfolio do to you?
First, a drop in your portfolio would significantly affect the rest of your financial situation. This is called your risk capacity. If you’re years away from a long-term goal, like retirement, the short-term declines in your portfolio aren’t necessarily that big, because your investments have decades to recover.
If your goal is in the near future, however, a big loss could derail your plans. If part of your portfolio was allocated to a down payment on a house this year, for example, you might not be able to afford a 24% drop.
Second, how would you feel if there was a big loss in your portfolio? The answer is, of course, bad – but how bad? “Sadly checking your brokerage account every morning” bad or “selling every investment you own in total panic” bad?
Investment professionals call your ability to stick to your financial plan in the face of investment losses your tolerance for risk. There’s nothing wrong with panicking when big red numbers start filling up your portfolio page, says Brad Klontz, certified financial planner and professor of financial psychology at Creighton University. But if you let that panic lead you to rash financial decisions, you could potentially hurt your finances, Klontz says.
“Who doesn’t freak out? If you’re on a roller coaster and your stomach turns, that’s normal,” he says. The problem comes when “it makes you want to jump off the carousel or never ride a roller coaster again.”
How to take the appropriate level of risk
If recent market turmoil hasn’t impacted your financial plans, your only next step is to stay the course. But if you’ve deviated from your plans or never had a plan in the first place, it’s time to get your wallet back on track.
Start with your risk capacity, suggests Benz: “Consider what you’re trying to accomplish and how close you are to when you need the money. You may need sub-portfolios for different goals.”
Typically, young people saving for retirement can invest that portion of their portfolio primarily in a broadly diversified range of stocks, Benz says. They offer higher long-term returns than other types of assets, but also tend to be riskier.
For short- or medium-term goals of one to three years, “consider adding safer assets like cash, short-term bond funds, and US government bond funds,” says Benz. From there, she adds, think about how you will react to losses in the future: “Risk capacity doesn’t matter if you’re going to upset your well-laid plan when you’re not. not comfortable with the losses you have suffered in the short-term.”
Many online questionnaires can help you determine your risk tolerance. Examining your behavior during the recent downdraft can be an equally useful yardstick, experts say.
“If I’m not comfortable in this type of up and down market, I need to remember that and put some safeguards in place so that I don’t feel like this the next time it happens” , says Kelly LaVigne, vice president of consumer insights. at Allianz Life. “Because it’s going to happen again. And you’ll still feel lousy.”
To avoid the kind of panic you may have felt in the first half of the year, consider reducing your allocations to riskier assets like stocks and cryptocurrency. You can also consider investing in a fund that manages the allocations for you.
“An all-in-one fund, such as a target date fund, can help you remove yourself from the equation and let the product do the heavy lifting,” says Benz.
A financial adviser may also be able to help on this front, says Levine: “The most important thing is to make sure you don’t follow your instincts and walk away from the market until you’ve spoken. to someone who can help you with your allowance.”
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