Risk is a normal part of investing – but it’s important to ensure you’re not taking on unnecessary risk. You’ll want to determine what level of risk you’re comfortable accepting and then balance it with the required risk necessary to achieve your long-term goals.
3 types of risk: Your risk level covers three main areas
Risk tolerance: Risk tolerance describes your emotional comfort with risk. Gauging your comfort with risk is important because it’s unlikely you’ll reach your long-term goals if you abandon your strategy during the inevitable short-term 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: This is basically your ability to handle risk. Your investment time horizon is often one of the biggest determining factors here. For example, if you’re younger, you have a longer time to make up for potential declines and could reasonably handle more volatility. If you’re retired, however, you likely have less ability to handle stock market declines.
Required risk: This describes how much risk you may need to take to reach your goals. In general, the higher the return needed to reach your goals, the more potential risk you’ll need to take to achieve them. As you discuss your goals with your financial advisor, you can determine this risk/return trade-off.
The balancing act
Typically, what prevents most investors from reaching their goals is not market volatility itself, but rather 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, you can better stick to your long-term strategy during the inevitable market downturns along the way.
In addition, sometimes there is a gap between how much risk you’re comfortable taking and how much you may need to take to achieve your goals. This is where you may need to make some important decisions. Your financial advisor can help you build a portfolio that balances your risk tolerance, risk capacity and required risk in order to achieve your financial goals.