You can buy millions of different investments, and they all involve the same big trade-off: risk versus reward.
In general, the greater the potential return on your investment, the more likely it is that it will lose value quickly. If you want to maximize the return on your portfolio, ask yourself: what will happen to me if my investments fall sharply?
The question requires a multi-faceted answer — one that examines how a decline in your portfolio affects your finances and how you react emotionally to losing money.
Many investors have been able to answer this question recently. The broader stock market fell nearly 24% between January and mid-June, with many individual stocks and more volatile assets like cryptocurrencies performing poorly.
If recent market volatility has hurt a little more than you think, it’s worth taking a moment to look within, says Christine Benz, Morningstar’s director of personal finance and retirement planning.
“A lot of people entered the market in 2020 and 2021 because it was uphill,” Benz tells CNBC Make It Record portfolio.”
According to market experts, here’s how to ensure you’re investing with the right level of risk.
Understand risk potential and risk tolerance
Back to the central question: What do you get if your portfolio falls sharply in value?
First, a decline in your portfolio has a significant impact on the rest of your financial picture. This is known as your risk tolerance. When you’re years away from a long-term goal like retirement, your portfolio doesn’t necessarily need to show a short-term decline because your investments have decades to recover.
However, if your goal is in the near future, a major loss can derail your plans. For example, if you earmarked a portion of your portfolio for a down payment on a house this year, you might not be able to afford the 24% drop.
Second, how would you feel if you lost a large amount on your portfolio? Of course, the answer is bad—but how bad? Is it bad to “seriously check your brokerage account every morning” or “sell every asset you own in a complete panic”?
Investment professionals call your risk tolerance your ability to stick to your financial plan in the event of an investment loss. When big red numbers start filling up your portfolio page, it’s okay to be nervous, says Brad Klontz, a board-certified financial planner and professor of financial psychology at Creighton University. But if you let that panic dictate financial decision-making, you could potentially do real damage to your finances, Klontz says.
“Who doesn’t panic? When you go down on a roller coaster and your stomach turns, that’s normal,” he says. The problem arises when “you feel like jumping off the ride or never riding a roller coaster again.”
How to take the right risk
If recent market volatility hasn’t impacted your financial plans, your next steps are to stay the course. But if you’ve strayed from your plans or have never made a plan before, it’s time to get your portfolio back on track.
Start with your risk tolerance, Benz suggests: “Think about what you want to achieve and how close you are to where you need the money. Maybe you need sub-portfolios for different goals.”
In general, young people who save for retirement can invest this part of their portfolio in broadly diversified stocks, says Benz. They offer higher long-term returns than other types of assets, but they also come with a higher level of risk.
“For short- or medium-term goals that fall between one and three years,” says Benz, “consider adding safe-haven assets like cash, short-term bond funds, and US Treasury funds.” From there, she adds. If so, consider how you will react to future losses: “The potential for risk doesn’t matter if you follow your well-planned plan when you’re short-term. Unpleasant with loss. -Condition.”
A series of online questionnaires can help you determine your risk tolerance. Experts say examining your behavior during recent downdrafts can be an equally useful measure.
“If I’m not comfortable in a volatile market like this, I need to remind myself and make it safe so next time it doesn’t happen,” says Kelly Lavigne, vice president of consumer insights. In Alliance Life. “Because it will happen again. And you’ll feel bad again.”
To avoid the kind of panic you may have felt during the first half of the year, consider reducing your allocation to riskier assets like stocks and cryptocurrencies. You can also consider investing in a fund that will manage the allocation for you.
“An all-in-one fund, such as a target date fund, can help you stay out of the equation and let the product do the heavy lifting,” says Benz.
A financial advisor can help on this front as well, Levine says: “The most important thing is to make sure you don’t go with your gut and get out of the market unless you’re from someone who is. Don’t talk, it may help you with your allocation.”
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