Frederick L Gaskin
When the market is going up and up, it’s easy for investors to think they’re more comfortable with risk than they actually are. Eventually, volatility returns and stocks and bonds can generate plenty of angst for investors. For many investors, this has been a very difficult year. In my experience, that’s often when people discover their true risk tolerance. Perhaps the single most important component of any successful investment strategy is determining your overall tolerance for risk. By answering this question correctly, investors might be able to manage to worry less, and potentially generate better returns.
It’s also important to realize that your tolerance for risk is not static. It will change over time, so it’s important to take stock every few years and confirm that your risks tolerance aligns with your investment portfolio, and long term financial planning goals and objectives. To help kick start this process, consider these simple three questions.
1. How much can I stand to lose emotionally?
The assets that offer the highest potential reward are often the riskier ones. Portfolios with larger allocations to stocks typically deliver higher returns over time, but they are also more volatile, which may not work for everyone. If you simply can’t bear to see your portfolio plummet in value, you might want to choose a more stable investment mix.
On the other hand, reducing your exposure to stocks and other relatively high-risk, high-reward assets during your peak earning years comes with its own kind of risk: falling short of your goal.
To help manage your emotional response to market volatility, consider cutting back on how often you review the performance of your long-term accounts. In fact, research suggests that the less often people check their investments, the more risk they will be comfortable taking.
2. How much can I stand to lose financially?
While many people think about risk in terms of their ability to endure losses emotionally, there’s another component to risk that’s equally important: your capacity to recover financially.
Time is the primary issue here. Those who have a decade or more before they expect to tap their savings can likely wait out some short-term volatility. For someone who may need the money sooner—in, say, five or fewer years—a market downturn can be devastating.
3. How well do I know myself?
It’s worthwile to try to square your financial capacity for risk with your emotional tolerance for it. What makes this hard is that humans are notoriously bad at predicting in advance how they’ll actually respond to a given set of conditions.
You might try asking someone close to you to rate your risk tolerance. A spouse or a close friend may be able to identify patterns of behavior that you don’t recognize in yourself. Financial advisors are also well suited to this role. Their experience with a broad range of clients can lend some perspective on where you fall along the spectrum of risk tolerance.
In the end, we encourage clients to keep things simple, and don’t overthink this process. If it doesn’t feel right, it probably isn’t. Importantly, figuring out how much risk you can really handle is an art as much as it is a science, and everyone’s unique. But when you have a better idea of how much you can stand to lose— both emotionally and financially—you can put together a plan that not only balances your long-term need for stability, growth, and income, but also allows you to be able to sleep at night.
As I’ve pointed out in prior columns, the hardest part for most clients in these situations is just getting started. Once you’ve jumped into the process, you’ll likely realize that by thoughtfully considering your tolerance for risk, you’ll might gain more confidence and importantly, a better understanding of what you need to do to manage your future.
Fred Gaskin is the branch leader at the Charles Schwab Independent Branch in Bluffton. He has over 35 years of experience helping clients achieve their financial goals. Some content provided here has been compiled from previously published articles authored by various parties at Schwab.
Information presented is for general informational purposes only and is not intended as personalized advice. Employees of Charles Schwab & Co., Inc. are not estate planning attorneys and cannot offer tax or legal advice, or create and prepare legal documents associated with such plans. Where such advice is necessary or appropriate, please consult a qualified legal or tax advisor.
(1022-2GWX)
