There are millions of different investments you can purchase, and they all require you to consider the same key trade-off: risk versus return.
In general, the higher the potential return on your investment, the more likely it is that the value will drop precipitously. When you are trying to maximize the return on your portfolio, ask yourself: What would a sharp drop in my investments do to me?
The question requires a multifaceted answer, one that examines both how a decline in your portfolio would materially affect your finances and how you react emotionally to losing money.
In recent times, many investors have been able to answer this question firsthand. The broad stock market fell nearly 24% between January and mid-June, and many more volatile individual stocks and assets, such as cryptocurrencies, fared far worse.
If recent market volatility has hurt a little more than you thought, consider taking a moment for some introspection, says Christine Benz, director of personal finance and retirement planning at Morningstar.
“A lot of people entered the market in 2020 and 2021 simply because it was going up,” Benz tells CNBC Make It. “Now is a good time to take a deep breath, step back and think about what the right amount of risk to be assumed in one’s portfolio “.
Here’s how to make sure you invest with the right level of risk, according to market experts.
Understanding risk capacity and tolerance
Returning to the central question: what would a sharp drop in the value of your portfolio do to you?
First, a decline in your portfolio would materially affect the rest of your financial picture. This is called risk capacity. If you’re just a few years away from a long-term goal, like retirement, short-term dips in your portfolio aren’t necessarily a big deal because your investments have decades to make up for.
If your goal is in the near future, however, a big loss could derail your plans. If, for example, you had set aside part of your portfolio for a down payment on a house this year, you might not be able to afford a 24% drop.
Second, how would a big loss in your wallet make you feel? The answer is, of course, no, but how serious? “Do I darkly check your brokerage account every morning” badly or “selling all the investments you own in total panic” bad?
Investment professionals call your ability to stick to your financial plan in the face of investment losses your risk tolerance. It’s okay to feel panicked when big red numbers start filling your wallet page, says Brad Klontz, a certified financial planner and professor of financial psychology at Creighton University. But if you let panic lead you to make rash financial decisions, you could potentially do real damage to your finances, Klontz says.
“Who doesn’t panic? If you’re on a roller coaster that’s going down and your stomach is churning, that’s normal,” he says. The problem arises when it “makes you want to jump out of the race or never ride a roller coaster again.”
How to take the right amount of risk
If the recent market instability hasn’t affected your financial plans, then your only next steps are to stay on 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, Benz suggests: “Consider what you are trying to accomplish and your closeness when you need the money. It may be that you need sub-portfolios for different goals.”
In general, young people who save for retirement can invest that portion of their portfolio predominantly in a broadly diversified range of stocks, says Benz. They offer higher long-term returns than other types of assets, but they also tend to carry greater risk.
For short- or medium-term goals ranging from one to three years, “consider adding safer assets like cash, short-term bond funds, and US government bond funds,” says Benz. From there, he adds, consider how you will react to losses in the future: “Risk capacity doesn’t matter if you’re going to reverse your well-structured plan when you’re uncomfortable with short-term losses.”
Numerous 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 kind of bull market, I need to remember it and put some protections in so I don’t feel like this next time it happens,” says Kelly LaVigne, vice president of consumer insights at Allianz Life. “Because it will happen again. And you will feel lousy again.”
To avoid the kind of panic you may have experienced in the first half of the year, consider reducing your allocations to riskier assets like stocks and cryptocurrency. You may also want to 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 take you out of the equation and let the product do the heavy lifting,” says Benz.
A financial advisor might be able to help on that front as well, says Levine: “The most important thing is to make sure you don’t follow your gut and pull out of the market until you talk to someone who can help you with your allocation.”
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