Assessing Your Risk Tolerance
While investors want the highest returns possible, remember that returns compensate you for the risks you take. Higher risks are generally rewarded with higher return potential. Thus, you need to assess how much risk you are willing to take. To get a feel for how much risk you can tolerate, ask yourself the following questions:
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 over a long time period to see if your estimates are reasonable. Expecting a high rate of return may mean that 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 more comfortable owning.
For what length of time are you investing?
Some investments 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 much could you lose in one-year period without selling the asset?
Don’t answer this question in percentage terms, since percentages often seem abstract. Quantify the answer in dollars based on your portfolio’s size. For instance, if you have a $400,000 portfolio, what would you do if your portfolio declined by 25 percent, or $100,000? If you’ve owned investments that have declined significantly in value, that will give you some indication of your reaction to losses.
How long would you be willing to sustain a loss before selling?
Investments do not always rebound quickly from declines. Could you remain invested for a two- or three-year period?
What types of investments do you own now and how comfortable are you with those investments?
Make sure you understand the basics of any investment you own, including the historical rate of return, the largest one year loss, and the associated risks. If you don’t understand an investment or are not comfortable owning it, you may be tempted to sell at an inopportune time.
If you’d like to better understand and assess your risk tolerance, please call Shelley Lee Boyce, CFP® at (760) 929-1180.