All investments involve a trade-off between risk and return. A certain amount of risk is inevitable if you want the potential for your money to grow. The key is determining how much risk you feel comfortable with.
Know Your Risk ToleranceAre you uncomfortable with change? Can you stick with your long-term strategy even if you face short-term losses? Will you be overly anxious the first time your investments drop in value? These are all questions to answer before developing your strategy.
Understanding your personal risk tolerance will help you create a plan you can stick with through good times and bad.
Many investors forget the risks involved with buying stocks when the market is soaring. Itís easy to be tempted by the lure of sky-high returns and to forget the possibility of a market downturn, or worse, of a bear market. Likewise, during a bear market or a sharp drop in the market, many investors suddenly become extremely risk averse. But if you create a plan built around your personal risk tolerance and stick with that plan, you will avoid having to make sudden changes in your investment strategy as the market changes.
Factors That May Affect Your Risk ToleranceAlthough your personality will affect your underlying risk tolerance, your stage of life also will affect it. Are you just getting started, supporting a growing family or approaching retirement? The amount of risk you feel comfortable taking may be very different at each of these stages in your life.
Most people arenít prepared for the risk posed by being 100% invested in stocks. But younger investors saving for retirement may be able to afford the risk of placing the bulk of their money in stocks. Why? Because in modern U.S. stock market history, investors have never lost real money investing over a 15-year period. Over a 10-year period, the odds of making money are more than 90%. So stocks have proven to be the best investment over the long term and will likely continue to be unless the U.S. economy crashes to a halt.
On the other hand, as you move closer to retirement, or if you will need a portion of your money in the short term, you may be better off foregoing the highest returns and putting your money in investments that are more secure, such as bonds or money market accounts.
But even investors with similar personalities and in the same stage of life may have different risk tolerances because of such factors as:
- Job security and future employment prospects. If you work in an industry with high turnover, you may be willing to risk less than if you are in a stable position with room for growth.
- The amount of disposable income available for investing. If you are investing millions you may be more comfortable taking risks than if you have only a few thousand dollars to work with.
- The risk of an unexpected financial burden. If you are the sole income provider for your family, your tolerance may be lower than if your spouse also earns a good living.