Most people poorly understand tolerance for investment risk. They also have a flawed – or even absent – understanding of the risk in their current investments.
Understanding risk tolerance and how it aligns with actual investment risk is crucial to your own investing. For instance, how do you respond not only to the downward jolts but also to euphoric market times? How does the current mood of the market affect your buying and selling decisions?
You can measure risk tolerance several ways, none ideal on its own. Most overly emphasize your age as the key factor, for instance.
You can take surveys to determine how you respond to certain circumstances; complete questionnaires that evaluate your preferences for growth versus protection; take personality tests relevant to investing. A combination, along with understanding your past investing behavior, works best.
You need a strong sense of your tolerance for fluctuations in markets because the best investment strategy for you – regardless of whether you’re conservative or aggressive with your portfolio – is the strategy you can stick with.
How much risk? Before labeling your investments as too risky, understand how risk relates to your financial goals.
A comprehensive financial plan that identifies whether your financial future is on track or at risk also helps you decide how much growth-seeking risk to take. Your plan can also identify the magnitude of risk in your financial life. Falling a few dollars short of your low-priority goals, for example, differs a lot from falling a few dollars short of your essential goals.