Assessing Your Risk Tolerance
Typically, before deciding how much to allocate to different investment categories, you answer several questions about your tolerance for risk. While it can be difficult to judge how you will react to different scenarios, the recent stock market fluctuations have provided a real-world test of theoretical answers. Many people have been surprised to find out that their tolerance for risk is not as high as they thought. That's not unusual. When the markets are performing well, it's easy to think you have a high tolerance for risk. But when the markets start to decline, our tolerance for losing money is not very high.
Thus, you should now have a better understanding of your comfort level with risk, making this a good time to reassess your risk tolerance. There are at least two components to your risk tolerance. One is the appropriate level of investment risk based on your personal situation. Factors such as your time horizon for investing, income level, total assets, debt levels, liquidity, and family responsibilities will affect that aspect.
The other element is your emotional tolerance for risk. Even if your personal situation indicates a high level of risk, that may not be prudent if you don't feel emotionally comfortable with that risk. How you have handled the recent stock market fluctuations should provide a good indication of your emotional comfort level with risk. How have you reacted during this volatile period? Have you taken the fluctuations in stride, or have you been anxious about your portfolio's value? Have you frequently calculated your portfolio's value or only occasionally checked? Have you been tempted to sell all your stock investments, or did you realize that this is a normal part of the investing process? What would you do if the market continued to decline? How long could you withstand a declining market before feeling compelled to sell?
One approach to develop an investment portfolio that reflects your individual risk tolerance is to consider your investment income needs and your attitude about the potential changes in investment values. If your standard of living is dependent on investment income, your portfolio should be concentrated in investments that provide stable and predictable income. However, if your living needs are covered through employment income, it makes more sense to take a little more risk with your investments, choosing investments with greater growth potential over the long run.
By knowing yourself and understanding your financial needs and goals, you will be better able to gauge how you may react to market fluctuations. In turn, this will help you determine what levels of risk to assume in your portfolio to help meet your financial goals.