Recently, the markets seem to just keep going up in value. But, don’t let this give you false optimism about the future. With every investment: you must be prepared for some kind of downturn or potential loss. You have to know your appropriate level of risk and how much of it you can take. “Risk” is the chance that you will lose your investment; it is also called, “volatility.”
Know How Much Risk You Can Take
To invest your money in ways that will benefit you, know your personal risk tolerance. Investopedia defines risk tolerance as the amount of fluctuation in returns that you are willing to potentially face when you invest. Your personal risk tolerance depends upon several factors – including your own behavior and mindset. Likewise, that risk tolerance affects several factors of your financial investments. As a result the success of your investments relies upon your own evaluation of, and engagement with, risk.
Your Long-term Investment Success Is About Risk Management
While many people believe that profitable investing is simply about “beating the Dow or S&P 500,” it is actually reliant upon risk management. This is because the amount of risk that you take in both long-term and short-term investments is correlated with the potential amount of money that you might receive in returns.
This can be seen in the range of volatility between stocks, bonds, and cash. Real assets – such as cash – tend to yield the lowest returns; however, the risk of these investments is also very low. Your returns may be very likely – but, they will be small. Bonds generally have a moderate level of risk while offering moderate potential returns. For short-term investing, then, more likely returns from these kinds of investments may suit your needs.
While stocks are typically regarded as having the greatest amount of risk, they also typically deliver the highest returns. According to a guide from the SEC, the potential for stocks to deliver high returns increases as times progresses. This means that long-term investing with stocks is more likely to yield greater returns than short-term investing with them.
You must decide how much volatility you can and will take. A low risk tolerance may lead you to choose cash or bonds; a high risk tolerance may lead you to stocks. If your investments are long-term, consider the effect of time on your overall reward. A report from Dalbar shows how not knowing one’s risk tolerance has resulted in a wealth of missed opportunities: in 2015, the average equity fund investor merely earned 4.67% instead of 8.19% from the S&P 500.
Investing Is About Time – Not Timing
The kind of investments that you choose – and the associated level of risk that you take – is related to the length of your investing activity. This predicted length of time for your investing is known as your time horizon. As we’ve already seen, longer time horizons favor high-risk choices such as stocks. However, you may have short-term assets or bonds in addition to those long-term investments. This use of diverse kinds of investments tends to reduce your overall risk while not significantly limiting your potential returns.
Asset Allocation – Is Your Portfolio Diversified?
In order to maximize your potential for returns, allocate funds to different kinds of investments. This placement of your investments into different classes is called “asset allocation”. Depending on how much risk or volatility you’re willing to take, invest with stocks, bonds, and cash in different amounts. Create a strategy to use your high-risk and low-risk investments in a specific way that matches your overall level of risk tolerance.
But, don’t stop there. Within each category of your investments – stocks, bonds, and cash – allocate funds to different individual securities. Invest in several different companies’ stocks or various kinds of bonds. This additional method of reducing your risk is called, “diversification.” To match your investment portfolio to your personal risk tolerance, make sure that your asset allocation represents a diverse range of securities.
Learn more about the relationship between asset allocation and diversification.
Rebalancing – What Is Your Current Asset Allocation?
If your asset allocation does not consistently align with your personal risk tolerance, you may face higher potential losses or lower potential returns than you really want. So, rebalance your investment portfolio, regularly. “Rebalancing” simply means to adjust your investments to match your personal goals. This may include selling certain assets to have less of that category in your portfolio or buying certain assets for the opposite reason.
Without rebalancing your investments, the level of risk that you take may not be at the same level of your risk tolerance. A prime example: the S&P 500 returned more than 12% in 2016 as bonds posted low single-digit returns. Were your assets properly allocated and diversified to reap the benefits of the stock rather than the bonds? Or, did you exhibit common investor behavior that prevented your investments’ growth (see Dalbar’s report)?
It All Goes Back to Risk Tolerance
Does your investment portfolio’s current diversification represent the volatility with which you are comfortable? How would you feel if your account-value decreased by 5%? What about decreases by 10%, 20%, or 30%?
Determining your personal risk tolerance is as much of an art as it is a science. You must consider not only your current situation – your age, total assets, personal savings rate, and lifestyle – but also your personality and your emotions. Dalbar’s report on investor behavior discusses the common tendencies that cause poor decision-making on the market. Loss aversion, optimism, and narrow framing all contribute to missing opportunities for growth and facing significant losses. Examine your own behavior and know how much risk you want to take with your investments.
Where to Go From Here
Your long-term retirement savings success depends upon your risk tolerance. It depends upon how you invest just as much as it depends upon the amount that you invest. By understanding your emotional and behavioral reactions to both good and bad markets, you can dial in a portfolio that works for you. Proper asset allocation, diversification, and rebalancing allow you to invest during years that the stock market does well. They also allow you to stay invested – and, keep investing – in years of decline.