A general principle of investing is that the bigger the financial risk, the bigger the potential reward. Buying stock in a company developing a groundbreaking drug could make you a fortune overnight, or if the drug isn’t approved, it could wipe out your savings just as quickly. On the other hand, putting that money in a no-risk certificate of deposit (CD) will get you a 2% return on investment, which is hardly enough to keep up with inflation.
Answering these four questions will help determine your investment risk tolerance and how much volatility you can comfortably live with.
1. How Old Are You?
Investment risk tolerance often changes with age. Your 20s and early 30s are the age to consider a stock-weighted portfolio. While the stock market is volatile, the potential rewards are high, and you have decades to recover from even a serious drop. Later, as you reach peak earning years, your expenses may be peaking as well, with children entering college and personal health costs rising. You may want to eliminate some risk by adjusting your portfolio to include a larger percentage of safer assets such as bonds. When you hit your 60s, balance becomes increasingly important: The sweet spot is a stable portfolio that grows steadily as you age.
2. How Long Do You Plan to Work?
The longer you plan to work, the riskier your investments can be. Even if the stock market wobbles and the value of your assets drop, you are pulling in a salary and won’t need to rely on your investments. You have time to wait and let the market stabilize. Considering the amount of time you plan to work and contribute to a retirement fund will help you determine your investment risk tolerance.
3. Is There a Large Expense in Your Near Future?
If you’re planning to buy a house, upgrade major equipment or send a child to college within the next few years, the stock market may be too erratic for your financial goals. At this stage, your risk tolerance is low. Although your portfolio will recover from a market drop over time, you probably don’t have the flexibility to wait it out. Think about a place where you can easily access your money, such as short-term bonds or high-yield savings accounts.
4. What Is Your Personal Comfort Level?
If your stomach lurches whenever the stock market dips, you should probably place more of your money in minimal-risk investments such as bonds or Treasury securities. Being ultra-conservative has its own downside, of course, and you may not reach the financial goal you’ve set for yourself. The trick is balancing peace of mind with the knowledge that playing it safe with a lower investment risk tolerance has limited rewards.