I dread this question…
“What should I buy today?”
There’s no good answer… How can I (or anyone) answer that question without knowing your goals or risk tolerance? Without knowing those factors (and a dozen others), my response is almost irrelevant.
Unfortunately, many investors don’t fully understand their risk tolerance.
If you’re new to investing, you may lack the confidence to take investment risks.
Maybe it has even kept you from investing at all, and you’ve missed out on the incredible gains from the current bull market.
Here’s the thing… Adding an appropriate amount of risk to your investments greatly improves your portfolio performance.
So today, I want you to assess your own risk tolerance. And I’ve included a three-step guide below to get you started…
First, let’s talk a little more about how to think about risk.
Risk in the market is measured by something called volatility. The more volatile the investment, the more the price swings up and down.
That’s why stocks are much riskier than bonds or money market accounts. Their prices are more likely to bounce up and down. That means that you stand to make a lot more money as the stock moves up, but you could also lose more as the stock falls.
If you’re taking on too much risk, your portfolio could take a big hit… especially if we go into a bear market.
Meanwhile, if you’re entirely risk-averse, you could miss out on the investments most likely to see major upswings.
Let’s review the common investment vehicles and where they fall on the risk spectrum:
As you can see, the least risky investments are cash and cash equivalents, like certificates of deposit. These are usually extremely stable investments, but ones that have low yields.
The riskiest, generally speaking, are stocks. Stocks are the most volatile, but also produce the biggest gains.
So when considering how much to invest in each asset class, start with a few simple questions. Write down your answers and keep them for reference whenever you make future investing decisions. In fact, it’s a good idea to review your plan and risk level each year. Consider the following:
1. How close are you to retirement?
A popular theory is the “100 minus age” rule. Take your age, subtract it from 100, and that’s the percentage you should invest in stocks. That means a 35-year-old woman should have about 65% of her portfolio in stocks.
The idea is that the younger you are, the more time you have to recover from losses. So you want to take on more risk earlier. However, this is still a general guideline. Everyone needs to determine how comfortable they are with that kind of risk – that’s why we need to answer two other questions…
2. What is your primary investing goal?
Are you looking to preserve your wealth, generate income, or grow your investments? These choices represent different levels of risk as well. For example, if you want to generate income, buying dividend-paying stocks will yield more than a typical savings bond, so you’ll want to account for that increase in risk.
One solution: Consider multiple accounts. We know a few folks not only have a conservative “retirement only” account, but also a trading account where they take on more risk. This is a great way to potentially earn big gains without doing damage to your retirement nest egg.
3. How much you are you willing to lose in a one-year period?
Before investing in anything, figure out how much you are comfortable losing and write it down. If you don’t want to risk much, opt for less risky investments.
Also, be disciplined about selling an investment if it falls by that amount… That’s how you keep losses from growing larger than you can handle.
These three guidelines are just the beginning of understanding your risk tolerance… but they’re a good place to start. So ask yourself these questions today. It’s one of the surest ways to improve your investing performance.
Here’s to our health, wealth, and a great retirement,
Dr. David Eifrig
Source: Daily Wealth