Risk is a normal part of investing – in fact, some risk serves a valuable purpose. If you didn’t accept some risk while investing, there wouldn’t be the potential to achieve higher returns. But it’s also important to ensure the amount of risk is appropriate based upon what you’re trying to accomplish.
3 areas to consider
- Risk Tolerance: Gauging risk tolerance (or your comfort with risk) and your potential behavior is important because it’s unlikely you’ll reach your long-term goals if you abandon your strategy during the inevitable market decline. Typically, you’ll be asked to complete a questionnaire that can gauge how you might react to risk in different situations.
- Risk Capacity: Risk capacity considers your ability to handle risk, and your investment time horizon is often one of the biggest determining factors. For example, if you’re younger and preparing for retirement, you have a long time to make up for potential declines and could reasonably handle more volatility. However, if you’re retired, your ability to handle stock market declines is likely smaller. Other items, such as income needs, may also influence your risk capacity.
- Required Risk: What level of risk is required to achieve your investment goals? The higher the return you need to reach your goals, the more potential risk you must take to achieve them, or other trade-offs (investing more, working longer, etc.) may need to be made. As you discuss your goals with your financial advisor, you can determine the risk/return and other trade-offs you may need to achieve them.
Risk, your emotions and your success
Typically, what prevents most investors from reaching their goals is not market volatility itself, but their reaction to it. Understanding your comfort level with risk can help you avoid some emotional investing mistakes, such as chasing performance. By knowing your risk tolerance in advance, you can better stick to your long-term strategy during the inevitable market corrections along the way.
What's right for you?
So how much risk makes sense for your situation? Ultimately, it’s the amount that balances how much risk you are comfortable with taking with the amount that you need to (and can) take to reach your goals. As you work to balance these items with the help of your financial advisor, you may need to make some difficult decisions and trade-offs to create an appropriate investment strategy that fits your needs. But ultimately, these decisions can help you avoid the biggest risk you face: not reaching your financial goals.