Talking Volatility: Magnitude vs. Percentage
Unfortunately, as human beings, we are prone to behavioral tendencies and mental shortcuts that do not always work in our favor.
The trade-off between risk and reward is a key part of any investment strategy. But risk means different things to different people. While risk is the key to unlocking greater gains, it can also be a source of sleepless nights. Each of us must find the right balance for our needs.
So how much risk are you willing to take on to reach your goals and sleep through the night? Figuring out your risk tolerance is a crucial step. It is an important building block for your investment plan and can help you create a portfolio that is well-positioned to meet your goals without compromising your financial (and emotional) health.
There is no simple equation for determining your risk tolerance, but the following three questions can serve as a guide.
Risk tolerance is not just an emotional attitude. It is also logistical, determined in large part by your goals and time horizon.
Consider your own investment goals. In addition to long-term goals such as retirement, you may be socking money away for shorter-term goals such as your child’s college education or a down payment on a home. When do you want to achieve each goal? This is your time horizon.
The longer your time horizon for each goal, the more time you have to ride out short-term volatility in the market and the more risk you can take on. The market can experience dramatic swings in the short-term, which usually means taking on less risk for the assets earmarked for spending on your short-term goals. For instance, you might wish to ensure there are enough low-risk, liquid funds in your 17-year-old’s 529 plan to cover their college expenses over the next several years.
Your risk capacity is your practical ability to take on risk. It is based on factors such as your savings, financial obligations, income level and job security. The more financially stable you are, the more capacity you may have to take on risk. However, if steep investment losses would hinder your ability to cover living expenses, pay down debt or meet shorter term goals, your risk capacity may be low.
Risk capacity can change over time in response to changes in your life. For instance, you might get a big raise or pay off big debts such as student loans or a mortgage. Either of those developments might make it easier for you to take on more risk. On the other hand, your risk capacity might decrease if you lose your job or take on new debt.
We have touched on your financial capacity to take on risk, but what about your emotional capacity? Hardly anyone enjoys seeing their portfolio take a nosedive. But how good are you at managing those feelings? This is your risk composure.
You may get excited about the idea of taking on more risk in hopes of earning larger returns. Or, that idea may give you excessive heartburn. That is an important difference, and one you need to consider if you do not want your investment portfolio to be a constant source of anxiety.
However you feel about the idea of investment risk, you also need to consider how you will actually react to a market downturn. Will you be able to stick to your long-term investment plan, despite any misgivings you may have along the way? Or, during the inevitable market corrections, will you be too tempted to change course, selling slumping assets and potentially missing out on a rebound?
If you struggle to keep calm and carry on in a downturn, you are not alone. There are several common behavioral biases that can hinder our ability to assess risk rationally. Learning to identify them can help you combat some of their counterproductive effects:
Everybody has their own emotional relationship to money as well as individual goals, time horizon and financial situation. Together, we can understand these factors and how they affect how much risk to take on in your portfolio. We can help you develop an investment strategy that hits the risk-return sweet spot, putting you in a position to realize your goals while protecting your fingernails.
Ready to develop your personalized risk profile? Give us a call at (732) 876-3777 to get started.
This post was written and first distributed by The Writing Company.
DISCLAIMERS
This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. This is not an offer to buy or sell a security.
Shore Point Advisors is an investment adviser located in Brielle, New Jersey. Shore Point Advisors is registered with the Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Shore Point Advisors only transacts business in states in which it is properly registered or is excluded or exempted from registration. Insurance products and services are offered through JCL Financial, LLC (“JCL”). Shore Point Advisors and JCL are affiliated entities.
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