Monday, July 10, 2017
Countdown to Financial Fitness: Know Your Tolerance for Risk
Countdown to Financial Fitness: Know Your Tolerance for Risk: You've paid down debt, built an emergency fund, and now you've finally saved up some money to invest. But before you hand your hard...
Know Your Tolerance for Risk
You've paid down debt, built an emergency fund, and now
you've finally saved up some money to invest. But before you hand your
hard-earned dollars to a broker, determine your tolerance for risk.
You can find sample "risk tolerance" questionnaires
on the internet. It's almost like a personality test. If you work with a
financial planner or investment counselor, he or she will most likely have you
take such a quiz, or at least ask you similar questions before setting you up
with a suitable investment plan.
Besides your age, income, assets, expenses, and plans for
your money, you will be asked questions like, "What percentage of your
investment are you prepared to lose?" and "How important is it for you
to keep up with inflation?" "Can you stomach putting some, or all, of
your principal at risk?" Some quizzes ask you what synonym for
"risk" comes to mind. Danger? Opportunity? Thrill? You might be given
scenarios to choose from: an investment that would never go down more than 10%
but would only gain a maximum of 5% versus an investment with the potential of
returning 30% but could lose 30% or more. Or you might see a question like,
would you prefer Door Number 1—$1000 as a sure thing—or Door Number 2, with a
25% chance to win $10,000?
It's important to understand how you react to risk before
choosing an investment. If an investment constantly keeps you awake at night,
it might not be appropriate for your portfolio. If you have to check your
account balance hourly and rush to sell your stock the first time its price
goes down, investing in the stock market might not be the right choice for you.
The stock market goes up and down, and if you get euphoric and buy when it's up
and panic-sell when it's down, you will lose money.
The younger you are, the more risk you can handle with
long-term investments, such as a retirement fund, provided you have the courage
to stay invested despite market fluctuations. Historically, the stock market
has yielded better returns than bonds or cash equivalents. Downturns actually
provide opportunity to grow your wealth by purchasing more shares of stock or a
mutual fund at a discount—if you stick to a plan of investing regularly. (You can do
this automatically by reinvesting dividends and capital gains, i.e.,
dollar-cost averaging.)
What some risk-averse investors don't realize is that, by
not investing in stocks or more aggressive mutual funds, by keeping all their
money in cash accounts where the principal is secure but growth is almost
non-existent, their nest egg may not keep up with inflation. And despite their
cautious approach, they still won't have enough money to live on in retirement.
So they are accepting risk whether they like it or not.
The closer you get to retirement, to the time when you will
begin living off your assets, the more conservative you'll want to become with
your investment allocation. Like with your emergency fund, you'll no longer
have time to weather a major downturn, and if you have to start withdrawing the
money, you'll be locking in losses.
Risk and reward go hand in hand. Aggressive investors are willing
to risk losing a chunk of money in exchange for the prospect of greater reward.
Conservative investors prefer to preserve their principal, but in exchange for
that security, they must accept more modest returns.
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