There are millions of different investments you can buy, and they all require you to consider the same major tradeoff: risk versus return.
Generally speaking, the higher the potential return on your investment, the more rapidly it can decline in value. When you’re looking to maximize your portfolio’s returns, ask yourself: What will a big drop in my investments do to me?
The question requires a multifaceted answer—one that examines both how a dip in your portfolio affects your finances physically and how you react emotionally to losing money.
Many investors have been able to answer this question of late. The broader stock market fell about 24% between January and mid-June, and many individual stocks and more volatile assets, such as cryptocurrencies, fared much worse.
If the recent market volatility is hurting you a little more than you thought, consider taking a moment for some introspection, says Christine Benz, Morningstar’s director of personal finance and retirement planning.
“A lot of people entered the market in 2020 and 2021 because it was growing,” Benz tells CNBC’s Make It. “Now is a good time to take a deep breath, step back and think about what is the right amount of risk in your portfolio.”
Here’s how to make sure you’re investing with the right level of risk, according to market experts.
Understanding risk capacity and risk tolerance
Back to the central question: What does a large drop in the value of your portfolio do to you?
First, a dip in your portfolio will materially affect the rest of your financial picture. This is called your risk appetite. If you’re years away from a long-term goal like retirement, a short-term drop in your portfolio isn’t necessarily a big deal because your investments have decades to recover.
If your goal is in the near future, however, a big loss can derail your plans. If you put some of your portfolio toward a down payment on a home this year, for example, you may not be able to afford a 24% drop.
Second, how does a large loss in your portfolio make you feel? The answer is of course bad – but how bad? “Seriously checking your brokerage account every morning” bad or “selling your every investment in a full-on panic” bad?
Your ability to stick to your financial plan when investors face investment losses is called your risk tolerance. Brad Klontz, a certified financial planner and professor of financial psychology at Creighton University, says it’s best to panic when big red numbers start filling your portfolio page. But if you let that panic make you rush into financial decisions, you could potentially do real damage to your finances, Klontz says.
“Who doesn’t get scared? If you’re on a roller coaster and your stomach is flipping, that’s normal,” he says. The problem arises when “it makes you want to jump off the ride or never ride a roller coaster again.”
How to take the right amount of risk
If the recent market volatility hasn’t affected your financial plans, your only next steps are to stay the course. But if you’ve deviated from your plans or had no plan in the first place, it’s time to get your portfolio on track.
Start with your risk appetite, Benz suggests: “Consider what you’re trying to achieve and your proximity to when you need the money. It may be that you need subdivisions for different goals.”
Typically, young people saving for retirement can invest that portion of their portfolio primarily in a widely diversified array of stocks, Benz says. They offer higher long-term returns than other types of assets, but also come with more risk.
For short- or intermediate-term goals of one to three years, “consider adding safe assets like cash, short-term bond funds and U.S. government bond funds,” Benz says. From there, she adds, consider how you’ll react to future losses: “Risk tolerance doesn’t matter if you’re going to scrap your well-laid plan when you’re uncomfortable with sustained losses in the short-term.”
Several online questionnaires can help you determine your tolerance for risk. Examining your behavior during a recent downdraft can be an equally useful benchmark, experts say.
“If I’m not comfortable with this type of up and down market, I have to remember it and put it in safety so I don’t think it will happen again,” says Kelly Lavigne, vice president of consumer insights. At Allianz Life. “Because it will happen again. And you’ll feel bad again.”
To avoid the kind of panic you felt in the first half of the year, consider reducing your allocation to riskier assets like stocks and cryptocurrencies. You can also consider investing in a fund that manages the allocation for you.
“An all-in-one fund like a target-date fund can take you out of the equation and help you do the heavy lifting,” Benz says.
A financial advisor may be able to help on that front as well, Levine says: “The biggest thing is to make sure you don’t follow your gut and get out of the market until you talk to someone who can help you with your allocation.”
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