Does Your Risk Tolerance Follow the Market?
According to an investment industry survey, in mid-2008 — when the financial crisis was still developing — 23% of U.S. households were willing to accept substantial or above-average investment risk in order to achieve substantial or above-average returns. The following year, after the stock market hit bottom, the percentage of risk-taking households fell to 19% and did not begin to rise until 2013, the fourth full year of the recovery and a strong year for market performance. Even so, risk-taking remained below the pre-crisis level through 2014 (most recent data available).1
It’s understandable that investors might feel less inclined to take risks when the market is down — after all, no one likes to watch the value of assets dwindle. However, your risk tolerance should be a fundamental component of your investment strategy, based on your own situation rather than market performance.
If you allow yourself to be swayed by the market, you might find yourself investing too heavily in riskier investments when prices are high and selling when prices have dropped, leaving you out of potential gains when the market rises again. On the other hand, if you become overly cautious and stick only to low-risk investments with little potential for gain, your savings may not keep pace with inflation over the long term.
By taking some time to assess your risk tolerance, you may be better able to construct and maintain an investment portfolio that fits your situation, regardless of market conditions. Your risk tolerance typically depends on several factors:
- Your time frame. The younger you are, the more time you may have to recover from potential losses. However, if you have a more immediate goal, such as saving for college, your time frame may be shorter than if you were focusing primarily on retirement.
- Your goals. You may have to assume more risk if you anticipate an expensive retirement lifestyle. Be careful not to assume too much risk just because you have expensive tastes!
- Other sources of income. If you are confident that you will receive retirement income from another source, such as a pension, a business, or an inheritance, you may be able to assume more investment risk. It’s generally not wise to place too much emphasis on Social Security in your calculations.
- Your personal style. Regardless of other factors, you have to feel comfortable with the risk you are taking. Will the risk of an investment substantially increase your stress level? If the answer is yes, you may be better off choosing a less risky investment.
Keep in mind that all investments involve some degree of risk, including the potential loss of principal, and there is no guarantee that any investment strategy will be successful. Risk tolerance varies from person to person, and there is no one-size-fits-all approach. The key is to consider the factors that could affect your own risk tolerance and make informed investment decisions appropriate for your situation.