When you began investing, you likely chose an investment portfolio model that aligned with your risk tolerance and time horizon. But since the financial markets are dynamic, the different investments in your portfolio will gain or lose value as different asset classes have good or bad years. This means that little by little, your portfolio could inch away from your ideal asset allocation and you may be taking on more risk than you’re comfortable with, or maybe not taking enough risk at all. When was the last time you looked at the contents of your portfolio? Is it time to reevaluate?
For simplicity’s sake, let’s say your desired asset allocation is 70% stocks and 30% bonds (this will vary based on your age, goals, and risk tolerance). As time goes on, stock prices rise, causing your allocation to shift to 80% stocks and 20% bonds. To rebalance your portfolio and keep your risk level stable, you’d have to sell some stocks and buy more bonds.
You may need to rebalance your portfolio by selling some of your overachievers to purchase underperformers. Though it may seem counterintuitive to sell off your winners, rebalancing is sometimes a wise and proven investment strategy to manage risk. First, you want to minimize your downside risk, the possibility of investments losing value. If you are overly invested in momentum or expensive stocks, downside risk could sting. Then you want to analyze your diversification risk. If you are under-diversified, invested in only a few stocks, your portfolio could suffer if one of these stocks plummeted.
So how do you figure out the right blend of assets that will get you where you want to go without risking your whole savings if things go south?
One thing I know is that you don’t want to figure out your risk tolerance accidentally. For example, you don’t want to go on an intense cycling trip through the mountains, reach the peak, and then be overcome with fear at the steep descent. At that point, it’s too late. You have to get down somehow. Similarly, you don’t want to get within 5 years of retirement and realize that you didn’t receive enough of a return on your investments to carry you through your retirement years.
Calculate different scenarios with different risk levels to get an idea of how much loss you are comfortable with. If you start to panic and cringe, then you know you’ve hit or passed your limit. Both positive and negative emotions frequently cause investors to make unwise decisions. If you’re excited about the upward swing of the market, you might throw caution to the wind and invest more money than you normally would. On the flip side, fear might drive you to react and sell if you start losing money.
By anticipating your limit for risk, you can simulate situations that cause those emotions so that you are prepared when they happen in real-time. This may help you stay focused on the long term and help you trust in your strategy.
Risk tolerance isn’t cut-and-dry. Here are a few factors that may help you determine how much risk you can handle:
Determining your personal risk tolerance involves analyzing your financial situation and balancing it with what you hope to achieve. And the closer you get to retirement, the more important it is to review and possibly adjust the investment mix in your portfolio to maintain the balance between managing risk and receiving your desired return. If you want to make sure you are on track toward your goals, schedule a call and meet me virtually.