Volatility is a given in investing. However, extreme volatility in the equity markets can be unnerving, even for experienced investors, and serve as a signal to step back and reassess your investing strategy. In general, regardless of volatility, reassessing your investment strategy at least once per year can be beneficial.
Identify Your Goals
Start the process of reassessing your investing approach by drawing up a list of the reasons why you are investing. For example, your goals might include retirement security, paying for your children’s college education, buying a bigger home or a second home, or financing a planned business. Be specific, and include estimates of how much you’ll need for each goal.
Balance Risk With Your Expectation of a Reasonable Return
Once you have outlined your goals, you’ll be ready to assess your risk tolerance. Risk tolerance is essentially your ability to accept the chance of investment losses in return for the possibility of earning higher returns. As an investor, you want to be able to earn a reasonable return on your invested assets while taking only the degree of risk you can tolerate comfortably.
Understanding your risk tolerance is crucial. Answering these questions can help you measure your risk tolerance:
When will I need the money?
All else being equal, you can assume a higher level of risk with your investments if you have time on your side. Time allows you the opportunity to potentially recover from investment losses.
However, if you’re investing for retirement and retirement is near, it may make sense to reduce the percentage of your portfolio that’s allocated to stocks and increase the percentage allocated to bonds and cash equivalents. Essentially, you will be transitioning from a growth strategy to one that is more focused on earning a more modest return and preserving whatever gains you’ve made.
Just how big an investment loss could I handle?
It’s easy to say an investment loss won’t really impact you. The reality is that you may overestimate your ability to handle a loss. You can better understand your own tolerance for risk if you translate an investment loss from percentages into real dollar terms. You could potentially see your portfolio decline by 15% (or more) in a severe market downturn. If your portfolio is worth $375,000, that 15% decline is $56,250. How well could you deal with a potential loss of that magnitude?
How will a loss impact my future plans?
It is only when you look at the impact of a potential loss in specific and measurable terms that you will be able to assess your ability to absorb investment risk. Would a significant decline in your portfolio’s value mean that you would have to delay your retirement date by a year or two or hold off on sending your children to the colleges of their choice? Thinking about risk in concrete terms can clarify your thinking about the level of investment risk you can tolerate.
Diversification Is a Key Strategy
Diversification simply means that you are spreading your investments among different securities and asset classes. Diversification helps reduce the risk that your portfolio’s overall value will be seriously affected if one security or asset type performs poorly. For example, if you have all your investments in stocks and the stock market drops, your portfolio’s value is likely to drop — perhaps significantly. But, if you diversify your investments and also hold bonds and cash equivalents, their performance may cushion the stock fund losses.
Managing and controlling the investment risk in your portfolio can help you sleep better at night and potentially bring you closer to achieving your investment goals. So, take the time to analyze how you have structured your portfolio and whether your current strategy is in line with your goals, your time frame for achieving those goals, and your capacity to absorb the risk of investment losses.
Additionally, a financial professional, like the team at Emerj360, will be able to offer insights into how well your investing strategy is working and offer suggestions about how to align your portfolio with your risk tolerance and goals.
