How to Evaluate Your Risk Tolerance
Investing is such a reactionary event for some people that it
becomes second nature to make changes based on the latest news or story
told around the water cooler. People believe that's the fastest way to
make a buck.
Not that making a buck is a bad thing--quite the contrary.
[In Pictures: 6 Numbers Every Investor Should Follow.]
The
issue is that very few people make money by investing based on the
latest headline or a passing comment at work. Investing takes time,
patience, and delving into the details to make sure you're getting a
fair deal. Most of us, however, aren't interested in putting aside the
time and doing it right. We want the instant gratification making a
change in our portfolio gives us--that short-term feeling of taking
control of the situation.
How do you overcome the need to take
action based on a gut reaction when it comes to your long-term savings?
You do a personality assessment.
Ask yourself these basic
questions, and don't try to fool yourself with the answers you think
you should have. There is no "right" answer. It's in your best interest
to be truthful.
1. What is your tolerance for negative investment performance?
2. How would you feel if the market and your account lost 20 percent of its value in six months?
3. How likely are you to change the answers to these questions if there are large swings in the market?
Once
you've answered the questions, you may want to ask someone who knows
you well to answer the same questions on your behalf. Having a third
party give their opinion about how they think you should respond will
help you see the answers from a different perspective. Maybe you've
felt all along that you are an aggressive investor, but your spouse
sees the worry in your eye with every market fluctuation. Having that
type of assessment should put you closer to a real evaluation.
Now compare your answers and the answers from your third party. Were you truthful? Were there any surprises?
Getting
answers to these questions is the start of determining your risk
preference: conservative, moderate, aggressive, or somewhere in between.
If your answers indicate you would have a negative reaction to
downward trends, you may have more conservative investing tendencies.
If you're more tolerant of the markets' ups and downs, then you could
be considered more aggressive.
If the outcome points to you
being a more conservative investor, you'll most likely have more bonds
and liquid assets, like a money market fund. Those who slide toward the
aggressive investing side of the scale would have more stocks rounding
out their portfolio. There will most likely be some cross-over between
asset classes regardless of your investing style.
The key is to
start with the base knowledge of who you really are as an investor.
Then you can build your portfolio based on the facts. There are plenty
of asset allocation calculators available to give you a more in-depth
look at your investing personality.
The
next step is to build a list of investment options that will fit in
the right asset categories. You'll be less likely to want to make
changes on the fly if you've created a solid plan. Your comfort level
with your investment choices will grow. The news and watercooler talk
will soon be just that for you--the news and talk, not your investment
plan.
It is normal to have feelings of uncertainty about our
assets when the market seems out of control. And it is normal to want to
do something to gain control of a seemingly off-the-rails freight
train. But if you take a few minutes up front to put a plan in to place,
you'll be less likely to react every time a headline catches your eye.
Scott Holsopple is the president and CEO of Smart401k,
offering easy-to-use, cost effective 401(k) advice and solutions for
the every-day investor. His advice has been featured on various news
outlets including FOX Business, USA Today, and The Wall Street Journal.
Keep tabs on Scott on Twitter and Facebook.
