When assessing your risk tolerance, think seriously about how much you could watch your savings drop before you panic.
Considering how often the term "risk tolerance" is bandied about in the investment world, you'd be surprised how much confusion surrounds it.
Many people believe that your appetite for risk rises and falls -- that is, you're more willing to take on risk during bull markets, less so during bears.
Not true, says Geoff Davey, director of FinaMetrica, an Australian firm that creates risk-profiling systems.
You have a set amount of risk that you're comfortable with. When you feel the urge to bail after a meltdown, your temperament didn't change; you misjudged the risks you were taking.
"People underestimate risk when markets are booming and overestimate it when there's a bust," says Davey.
So how can you get a better handle on this crucial concept and develop an investing strategy?
For starters, think seriously about how much you could watch your savings drop before you panic.
From the market's 2007 peak to the 2009 trough, stock values plunged more than 50%, while intermediate-term government bonds rose roughly 6%. A portfolio of 90% stocks and 10% bonds fell 45%; a fifty-fifty mix was down about 22%.
If you think 20% or so is the most heat you could stand, a 50% stock stake is probably close to your upper limit, even though that's far less than what's often suggested for someone your age.
You could also fill out one of the many risk-tolerance questionnaires available online. The problem is, most tend to focus on how much risk you ought to take with your investments, not the swings you're prepared to handle.
A notable exception is FinaMetrica's questionnaire (Cost: $45), which gives you a numerical risk-tolerance score on a scale of 1 to 100 that corresponds to the percentage of risky assets that's appropriate for someone like you.
You may, however, discover a gap between the amount of risk you can tolerate and the amount you must embrace to reach your goals.
Say you prefer a fifty-fifty stock/ bond split but, given what you're saving, you need upwards of 70% in stocks to generate the necessary returns. You could buy more stocks in hopes of higher gains, but investing too far outside your comfort zone could backfire. You could end up selling at a big loss during a downturn.
The better option: Adhere to a portfolio you can handle and make other adjustments, such as saving more, working longer, or scaling back your retirement lifestyle.
Finally, most people become less tolerant of risk as they age. But even if you're okay with the same stock-heavy mix at 65 that you had in your thirties, you'll probably still want to dial back. The same loss you shook off in your youth could so deplete your nest egg in retirement that it might never recover.
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