Whether the stock market is riding a rollercoaster or your investments are sailing smooth, understanding your own risk tolerance is imperative to making and maintaining sound decisions.
Not only can the wrong asset allocation send a portfolio’s trajectory in the completely wrong direction, but it can also keep investors up at night or push them to make a bad decision in a panic. Financial advisers will assist their clients when making investment choices for their retirement accounts, but individuals who are contributing to an employer-sponsored retirement account or managing a portfolio on their own should conduct a check-up themselves.
Many of the major investment firms that offer investment portfolios have risk tolerance questionnaires for investors, which ask a series of questions about money and their comfort level with the stock market. Individuals will answer questions pertaining to their investments, such as how much time will pass before they need the money, and the results typically provide a suggestion for how to allocate the portfolio based on that information. Think of this as a starting point — it’s not the same as talking to a financial planner who can ask deeper questions or get a sense of how confident a person is in their answers.
Vanguard’s questionnaire asks 11 questions, including: when and how investors plan to use the money from their investments, how much they agree or disagree with feelings about market movement and hypothetical questions based on previous market history. Schwab has a similar questionnaire that determines the investor’s “profile,” and then offers suggestions based on those results and whether a person’s investing personality is considered conservative, moderately conservative, moderate, moderately aggressive or aggressive.
When completing these questionnaires, it’s also critical to remember that how you feel today may not be how you feel when the stock market is acting differently in a week, month or year. For example, when answering questions while her portfolio’s balance is climbing day after day, an investor may think she feels more comfortable with risk — until a month later when a correction hits and she loses a percentage of that balance. The opposite is also true — an investor may think he’s too nervous to have any risk in his portfolio because the market is acting up, but then lose out on potential returns over the next few decades until retirement.
Other firms, like Betterment, include factors such as time horizon and downside risk, into their asset allocation suggestions when an investor is creating a portfolio. The company creates a glide path, similar to those that target-date funds use, which recommends portfolios become more conservative the closer to the goal’s deadline. Investors can follow the suggestions or deviate from them.
There’s one more thing to consider when determining risk tolerance — risk capacity. That means how much risk a portfolio needs or could use to reach the investor’s goals. For instance: a 30-year-old investor planning to retire at 65 would normally be advised to invest aggressively to achieve her goal of having millions in retirement, but if she’s afraid of risk in her portfolio and only invests in highly conservative options, that goal might be hard to accomplish. Financial planners can also talk clients through these decisions, but if investors are working alone, they should consider what amount of risk they could reasonably expect to need — and how to become more comfortable with it.
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Original source: MarketWatch