There are millions of different investments you can buy, and they all require you to consider the same key trade-off: risk versus return.
Generally speaking, the higher the potential returns on your investment, the more likely it is to decline sharply in value. When looking to maximize your portfolio’s performance, ask yourself: What would a big decline in my investments do for me?
The question requires a multifaceted answer: one that examines how a drop in your portfolio would materially affect your finances and how you react emotionally to losing money.
Many investors have been able to answer this question firsthand lately. The broad stock market fell nearly 24% between January and mid-June, with many individual stocks and more volatile assets such as cryptocurrencies faring much worse.
If the recent market volatility hurt a little more than you thought, consider taking a moment to do some introspection, says Christine Benz, director of personal finance and retirement planning at Morningstar.
“A lot of people got into 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 is the right amount of risk to take on in your portfolio.”
Here’s how to make sure you’re investing with the right level of risk, according to market experts.
Understand risk capacity and risk tolerance
Back to the central question: What would a large decline in the value of your portfolio do for you?
First, a drop in your portfolio would materially affect the rest of your financial picture. This is called your risk capacity. If you’re 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 recover.
However, if your goal is in the near future, a big loss could derail your plans. If you had a portion of your portfolio earmarked for a down payment on a house this year, for example, you may not be able to afford a 24% drop.
Second, how would a big loss make you feel in your portfolio? The answer is, of course, bad, but how bad? “Seriously check your brokerage account every morning” bad or “sell every investment you have in a total panic” bad?
Investment professionals refer to your ability to stick to your financial plan in the face of investment losses as your risk tolerance. It’s okay to panic when the big red numbers start filling your portfolio page, says Brad Klontz, a certified financial planner and professor of financial psychology at Creighton University. But if you let that panic lead you to make hasty financial decisions, you could be doing real damage to your finances, Klontz says.
“Who doesn’t get scared? If you’re on a roller coaster going down and your stomach turns, that’s normal,” he says. The problem arises when you “want to jump off the ride or never ride a roller coaster again.”
How to take the right risk
If the recent market turmoil hasn’t affected your financial plans, your only steps are to stay the 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 in order.
Start with your risk appetite, suggests Benz: “Think about what you’re trying to achieve and how close you are to when you need the money. You may need sub-portfolios for different goals.”
In general, younger people saving for retirement can invest that portion of their portfolio primarily in a broad, diversified range of stocks, Benz says. They offer higher long-term returns than other types of assets, but they also tend to carry more risk.
For short- to medium-term goals that are between one and three years, “consider adding safer assets like cash, short-term bond funds, and U.S. government bond funds,” says Benz. From there, he adds, consider how you’ll react to losses in the future: “Risk capacity doesn’t matter if it’s going to upend your well-laid plan when you’re uncomfortable with the losses you suffered in the short term. -term .”
Many online quizzes can help you determine your risk tolerance. Examining your behavior during the recent downdraft can be an equally useful yardstick, experts say.
“If I don’t feel comfortable in that kind of up and down market, I have to remember that and put in protections so I don’t feel that way the next time it happens,” says Kelly LaVigne, vice president of consumer information. at Allianz Life. “Because it’s going to happen again. And you’re going to feel bad again.”
To avoid the kind of panic you might have felt in the first half of the year, consider reducing your allocations to riskier assets like stocks and cryptocurrency. You can also consider investing in a fund that manages the allocations for you.
“An all-in-one fund, such as a target date fund, can help remove you from the equation and let the product do the heavy lifting,” says Benz.
A financial advisor can also help in this regard, says Levine: “The most important thing is to make sure that you don’t follow your gut and get out of the market until you talk to someone who can help you with your allocation.”
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