As Warren Buffet famously said, “The first rule of investing is don’t lose money. The second rule is don’t forget rule number 1.” But when you’re watching major indices decline rapidly over days, will Buffet’s word prevail or will the urge to hit the sell button rule?
Conceptually, many investors do understand why panic selling is never a good idea. You not only lock in what was originally a paper loss but also miss out on the market recovery. Case in point: Over any 20-year period, the US stock market has never lost money, even after considering the 2008 financial crisis or the 2000 dot-com bubble burst. But when the stock market goes into a freefall, there’s no guarantee investors will react to the volatility the way they think they will.
That’s why it’s so important to understand your own risk tolerance and figure out your risk profile. All investments come with risk, and investors care most about downside risk – the chance that they might lose money on their investment.
Determining how much risk you’re comfortable taking and selecting a portfolio risk level that fits your risk tolerance and financial goals is key to ensuring you don’t make investment decisions you may regret.
What’s The Right Level Of Risk You Should Take?
To determine whether you’re at the right risk level, first ask yourself how much risk you can realistically tolerate. A useful exercise is to think about you reacted during the 2008 financial crisis (or imagine how you’d have reacted). Did you sell all your investments in fear; suffer sleepless nights and sell 50% of your portfolio; or did you choose to maintain your portfolio and not sell?
For a more nuanced evaluation of your risk tolerance, consider taking a risk assessment. Many digital wealth managers like Syfe have their own risk questionnaires. Banks and other investment firms offer them as well.
The second step is to consider your risk capacity. This is closely tied to your investment horizon. Younger investors can generally afford to take on higher risk as they have more time to ride out the inevitable rough patches. They can allocate a higher proportion of stocks to their portfolio since stocks tend to outperform bonds over the long term.
For investors who have a shorter investment horizon, such as those nearing retirement, having a larger percentage of their portfolio in less-risky assets like bonds will be a better option since they may not have sufficient time to recover from any large losses.
Finally, think about whether you need to take the risk. Determine the investment return you will need in order to meet your financial goals. If you only need a 5% return, it might be unwise to take on excessive risk. If you need a 12% return but are not comfortable with the additional risk you’d need to take, it may be time to reassess your goals – or think about whether you can increase your savings rate.
What Else Should You Do To Manage Investment Risk?
Taken together, your risk tolerance, risk capacity and risk requirements form your overall risk profile. A good wealth manager will be able to help you select the right risk level for your portfolio based on your risk profile. Determining your ideal portfolio risk level essentially boils down to your asset allocation. A larger proportion of stocks in your portfolio will mean your portfolio risk is higher – but you may potentially enjoy higher returns as well.
Don’t forget to ensure your portfolio is well-diversified, preferably across different asset classes, sectors and geographies. The lack of correlation between how various asset classes behave can help you reduce the impact of market volatility.
Now that volatility is back, give your risk profile and portfolio risk level some thought. Don’t wait until the worst has happened to find out what you can really handle in terms of risk.
This article was first published on DollarsAndSense as a guest post.