While investors want the highest returns possible, returns compensate you for the risks you take - higher risks are generally rewarded with higher returns. Thus, you need to assess how much risk you are willing to take to obtain potentially higher returns. However, this can be a difficult task. It is one thing to theoretically answer questions about how you would react in different circumstances and quite another to actually watch your investments decrease significantly in value. What you are trying to assess is your emotional tolerance for risk, or how much price volatility you are comfortable with. Some questions that can help you gauge that risk tolerance include:
- What long-term annual rate of return do you expect to earn on your investments?
Your answer will help determine the types of investments you need to choose to meet that target. Review historical rates of return, as well as variations in those returns, over a long time period to see if your estimates are reasonable. Expecting a high rate of return may mean you'll have to invest in asset classes you aren't comfortable with, or that you may be tempted to sell frequently. A better alternative may be to lower your expectations and invest in assets you are comfortable owning.
- What length of time are you investing for?
Some investments, such as stocks, should only be purchased for long time horizons. Using them for short-term purposes may increase the risk in your portfolio, since you may be forced to sell during a market downturn.
- How long are you willing to sustain a loss before selling?
The market volatility of the past few years will give you some indication of how comfortable you are holding investments with losses.
- What types of investments do you own now and how comfortable are you with those investments?
Make sure you understand the basics of any investments you own, including the historical rate of return, the largest one-year loss, and the risks the investment is subject to. If you don't understand an investment or are not comfortable owning it, you may be tempted to sell at an inopportune time. Over time, your comfort level with risk should increase as your understanding of how risk impacts different investments increases.
- Have you reassessed your financial goals recently?
Due to the significant market volatility of the past few years, your financial plan may need to be revamped. Otherwise, you may find you won't have sufficient resources in the future to meet your goals. Based on your current investment values, determine what needs to be done to meet your financial goals. You may need to save more, change or eliminate some goals, or delay your retirement date.
- Do you understand ways to reduce the risk in your portfolio?
While all investments are subject to risk, there are some risk reduction strategies you should consider for your portfolio. These strategies include diversifying your portfolio and staying in the market through different market cycles.